Rule Number One: Don’t Blow Up
- Joshua M Brown
- March 17th, 2014
Something tells me there are some serious blow-ups on the horizon for professional managers.
I feel this because stock market returns have been explosive – specifically in high beta, high octane names – and investors’ expectations for future returns tend to extrapolative. As profits increase, so too do their beliefs that even more gains are coming. In an atmosphere like this people begin to lose perspective and become accustomed to the miraculous. They push those who manage money for them for the unattainable and professionals eventually succumb.
This is the main reason guys blow up in my industry. When your business is managing “other peoples money”, those “other peoples” can have quite an influence on how you manage. Almost no one is entirely immune. Jeremy Grantham just admitted to Barron’s this weekend that even though the stock market is “65% overvalued” and has an almost nil expected return over the next seven years, he’s 49% long equities in the fund he runs at the moment. The music’s playing, after all.
This past summer I was at the CNBC / Institutional Investor-sponsored conference Delivering Alpha 2013. My friend Kelly Evans hosted an interesting panel about Asset Bubbles and how they can (or cannot) be avoided by institutional investors. The panelists were hedge fund managers and the guy who runs the Wisconsin state pension fund. The consensus seemed to be that asset bubbles are a part of life if you’re in the game and they can be capitalized on but not wrung out of the system, no matter what precautions regulators attempt. Policy can abet them, make them worse and even play a role in how long they’re permitted to go on – but people being people, bubbles are inevitable, as are casualties.
One of the panelists made a remark that left an impression on me in terms of how professionals can avoid blowing up when a bubble bursts. Michael Sacks of Grosvenor Capital Management framed it as an issue of investor expectations rather than a function of trading prowess, research capabilities or clairvoyance. “The key question for institutional investment people is ‘How do you structure your relationships with asset managers to avoid investing in asset bubbles?’”
Sacks is talking about the types of conversations and compensation arrangements that institutions have with their managers in advance. If it is clear that chasing a bubble is not the client’s expectation – nor will it lead to windfall fees – money managers will not feel compelled to do it. Professional managers serving institutions will abstain from the riskier type of behavior that is always required for excess returns in the final phase of a bull market provided they’re not given any reason to think they’re supposed to.
I agree with this idea and I think that behavior-as-risk-mitigation is far superior to any kind of technique by which the end of the bubble is predicted in advance or shortly afterward. Most market participants are obsessed with the latter unfortunately – the idea of pinpointing where the train tracks end is a holy grail of sorts. Unfortunately, nailing the top of even the most speculative mania is probably not humanly possible on a consistent basis but the illusion that it is gives managers way more confidence than is warranted by history.
So how can a professional avoid getting caught up in the next asset bubble? I’ve learned that taking on the right clients and setting expectations is the key.
Having an adult discussion with the client you may end up managing money for about what you will and will not be risking to generate returns is a good first step. Past performance often doesn’t demonstrate enough about what kinds of things a firm has actually done to earn them – and in what kind of environments. Anecdotes and historical analogies would probably be helpful in filling in these blanks – “Here’s a recent opportunity we passed up and why,” or “Here’s a scenario in which we are more likely to be selling than adding to positions.”
It may be that you are not aggressive enough to meet that particular client’s mandate. This is a good thing to know now, so that you are not expected to gallop around the final turn at breakneck speed during the next derby.
Jean-Marie Eveillard of First Eagle Global fame, one of history’s greatest value investors, once quipped “I’d rather lose half my clients than half my clients’ money” when asked why he refused to join the dot com orgy at the turn of century. He was roundly mocked for not playing along with the New Paradigm – as were Warren Buffett and Jeremy Grantham – until they weren’t. And any assets that had fled during the risk chase were replaced (and then some) after the crash. Now, of course, to make a statement like this in the relative performance world we inhabit, you’d better hope a crash of some sort immediately follows – but that’s another story.
The point here is that Eveillard was smart enough to say no to the AUM that might have come along had he dove head-first into speculation. There’s a great lesson here in terms of setting expectations and letting prospective investors know what’s not going to happen.
Getting back to “the right clients”, I’m going to share some lessons I learned the hard way during my career. If you’re a fellow professional money manager or advisor, it is likely that you’ll be nodding your head in agreement as you read this. If I’m saying the things out loud here that you wish you could, then I’m doing my job here on the blog.
A few years ago, I decided I wasn’t going to take on any more unreasonable, dangerous clients. I had too much responsibility to the households I was taking care of to allow a handful of lunatics distract me or goad me into investing behavior that I knew for a fact was stupid. Anyone who’s been in my line of work has likely reached a similar moment of clarity at some point. Or, at least, they will.
A small but vocal minority of wealthy people in this world believe that because they’ve been successful in their career, this success ought to automatically translate to any endeavor they get involved with (think about a retired major league baseball player opening a fine dining restaurant) and they view profits from speculation as something of an automatic, god-given right. I’ve ended up on phone calls or in meetings with quite a few of them over the years. I’ve learned that they are fearless about losses (because they can easily replace them), that they expect a super-sophisticated approach to investing and that they have outrageous ideas about what is possible in the markets.
The typical expectation of these types of investors is something along the lines of “I want all the gains of the hottest stocks out there, none of the losses of a general market decline, I want the ability to override your decisions if they look to be wrong and I want a running commentary from you about what you’re buying and selling every step of the way so that I can play along at home. Also, I’ll be logging into my account hourly from a mobile phone and checking you versus the benchmark nightly.”
If this is your bread-and-butter client, I wish you luck.
Professional money managers with experience and good instincts learn to Just Say No to these types of clients in advance, no matter how much money they dangle in front of them. They are a nightmare and an accident waiting to happen – no amount of remuneration makes these relationships work for any length of time. But when you’re new in the industry or just ramping up a new fund or trading service, sometimes these are the only clients you can get. They’re eager for action and the managers who are most willing to promise it to them will get the check in the mail fastest.
I have a trader friend who runs his own money and took on a client after weeks of persistent begging and enticement. He began to trade for the guy’s account and was invited to his home – a ridiculous mansion somewhere nearby. While there, he learned that the client had installed a cannon blast sound effect to boom through speakers all over the house every time my friend did a buy or sell in his account. There’s vicarious and then there’s this. The trader, freaked out, gave him his money back shortly afterward.
Years ago, I listened in as my partner Barry took a call from an “investor” who’d amassed four million dollars in liquid assets and wanted to turn over a million each to four different managers, “the best performer over the next six months gets the whole thing”. Barry asked if he understood the reckless incentive he was offering out there – swing for the fences, if you get crushed, who cares – it’s not your money to keep managing anyway! – but he was adamant that this was how he wanted to select an advisor. Barry’s response was “I’ll tell you what – go off on your trading adventures, and if in five years you have enough money left to meet our minimum, give us a call then.”
I know some smaller managers who are going through this torture now. They can’t fire these clients because it’s their only source of revenue. They’re trying in vain to “re-train” these clients after the fact, but this is like asking a leopard to be a lemur – we’re talking deep-seated, ingrained personality issues here, there is no deprogramming for these folks until they either find a new hobby or lose all their money.
Not only can’t the managers please this type of client no matter what, they also can’t think straight or function properly for their other, more reasonable clients. It’s a terrible situation.
I know of only one solution. Accepting that you cannot be everything to everybody. Deciding on an asset management approach and committing to it, even during moments when other approaches look sexier. Setting expectations up front about one’s strategy and denying funds from any potential investor who doesn’t get it takes maturity and long-term thinking. It’s also the key to success as a professional. As advisors and stewards of our clients’ investments, we have a responsibility to them and this means not allowing distractions and the stress of miscommunication to impair our abilities.
Life is too short and markets are difficult enough already.
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The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.