July 15, 2003

Volume 2, Issue 14

Investing: Profession or Business?

Thoughts on Beating the Market Index

I’m beginning to wonder how to persuade the businessperson who owns a large
investment management organization that the first and essential priority is to protect the
vital core: the classic disciplines of investing as a profession.
Charles D. Ellis
1
Will Business Success Spoil the Investment Management Profession?

There seems to be some perverse human characteristic that likes to make easy things
difficult. It’s likely to continue that way. Ships will sail around the world but the Flat Earth
Society will flourish.
Warren Buffett
2
The Superinvestors of Graham-and-Doddsville

The Scouting Report

To prepare to win, most teams scout their competition. The objective is to create a game
plan that exploits the competition’s weaknesses and neutralizes its strengths. Teams
generally consider intelligent scouting vital to their long-term success.
So what’s the competition for a money manager? Investors with particular objectives can
typically invest either with active managers or with index funds. For example, an investor
seeking exposure to large-capitalization stocks can place money with a large-cap active
manager or with an index fund that mirrors the S&P 500.
Accordingly, we can consider an appropriate index’s return to be a measure of an
investor’s opportunity cost—the cost of capital—and that beating the benchmark over time
should be an active manager’s measure of success.
Michael J. Mauboussin So how do active managers fare against the competition? Not well. Over a recent five-
212-325-3108
michael.mauboussin@csfb.com year period, the indexes outperformed about 70% of all active managers, and about three-
quarters of active funds underperformed the benchmark over 10 years. And this type of
Kristen Bartholdson 3
result has been consistent over time. Given how well the indexes have fared, it might be
212-325-2788
kristen.bartholdson@csfb.com
useful to provide a scouting report on how the indexes compete.
The most widely used benchmark for equity fund performance is the S&P 500. The S&P
Index Committee uses five main criteria when looking for index candidates. Here they
are—the heart of the strategy that beats the majority of active managers, year-in and
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year-out:
1. Liquidity. As the committee wants the benchmark to be “investable,” it selects stocks
with sufficient liquidity (a ratio of monthly trading volume divided by shares
outstanding of 0.3) and float.
2. Fundamental analysis. The profitability criteria are “four quarters of positive net
income on an operating basis.” That’s it.
 3. Market capitalization. For the S&P 500, there are no market capitalization restrictions, but “the
guiding principle for inclusion in the S&P 500 is leading companies in leading U.S. industries.”
4. Sector representation. The committee tries to keep the weight of each sector in-line with the sector
weightings of the universe. It typically does so by adding stocks in underweighted sectors, not by
removing stocks in overweighted sectors.
5. Lack of representation. S&P defines the lack of representation as follows, “If the index were
created today, this company would not be included because it fails to meet one or more of the
above criteria.” Of the more than 1,000 companies removed from the S&P 500 over the past 75
years, the overwhelming majority were the result of mergers and acquisitions.
Our scouting report of the S&P 500 might also note that the committee does no macroeconomic
forecasting, invests long-term with low portfolio turnover, and is unconstrained by sector or industry
limitations, position weightings, investment style parameters, or performance pressures. Also critical is
that index funds closely track the S&P 500 at a very low cost.

Evaluating the Winners

Some actively managed funds clearly do beat the benchmark, even over longer time periods. To see if
we could come to some stylized conclusions about how these successful investors did it, we created a
screen of the general equity funds that beat the S&P 500 over the past decade (ended the most
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recently reported fiscal year) where the fund had one manager and assets in excess of $1 billion.

Exhibit 1: Some General Equity Funds that Beat the S&P 500 (1992–2002)
Ten Year Ten Year After Assets in Top
Fund Name Return Tax Return Turnover Ten Holdings
Calamos Growth A 18.7 % 15.3 % 79 % 21.5 %
Fidelity New Millennium 17.2 14.5 91 30.3
Legg Mason Value Trust 16.6 15.3 25 51.9
WasatchCore
Core Growth 16.0 13.5 76 46.1
Janus Small Cap Value Institutional 15.8 12.8 39 22.5
Clipper 15.5 12.3 48 51.9
Weitz Partners Value 15.4 13.2 10 50.8
Excelsior Value & Restructuring 15.4 14.7 8 28.1
Weitz Value 14.9 12.9 13 50.1
Longleaf Partners 14.8 12.4 18 57.7
Sequoia 14.8 13.2 8 79.4
Fidelity Low - Priced Stock 14.7 11.6 26 17.1
Smith Barney Aggressive Growth 14.6 13.9 1 53.0
Vanguard Primecap 13.9 12.7 11 35.6
Dodge & Cox Stock 13.8 11.7 13 23.7
Torray 13.5 12.5 23 40.1
T. Rowe Price Mid Cap Growth 13.5 12.7 36 20.6
GabelliValue A 13.3 9.9 16 39.9
Longleaf Partners Small- Cap 13.2 11.5 17 60.0
Heartland Value 13.0 11.2 49 19.3
American Funds Growth Fund of America 12.7 10.2 30 22.7
Federated Kaufmann K 12.5 10.4 65 34.5
Ariel 12.5 9.9 6 36.9
Scudder Dreman High Return Equity A 12.4 10.2 25 52.0
T. Rowe Price Small - Cap Value 12.3 10.6 12 14.9
Liberty Acorn Fund Z 12.3 10.1 13 13.2
Elfun Trusts 12.1 10.0 9 38.9
Franklin Small - Mid Cap Growth 12.1 10.3 47 16.5
PIMCO NFJ Small Cap Value Institutional 12.1 9.9 40 10.2
Dreyfus Appreciation 10.9 10.2 2 41.9
White Oak Growth Stock 10.5 10.4 15 61.5
Average 13.9 % 11.9 % 28 % 36.9%
36.9

Vanguard 500 Index 9.9 % 9.0 % 7% 24.1%

Vanguard Total Stock Mkt Idx 9.3 8.5 9 19.4

Source: Morningstar.com.
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 Four attributes generally set this group apart from the majority of active equity mutual fund managers:
• Portfolio turnover. As a whole, this group of investors had about 30% turnover, which stands in
stark contrast to turnover for all equity funds of 110%. The S&P 500 index fund turnover was 7%.
Stated differently, the successful group had an average holding period of approximately three
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years, versus less than one year for the average fund.
• Portfolio concentration. The long-term outperformers tend to have higher portfolio concentration
than the index. For example, these portfolios have, on average 37% of assets in their top-10
holdings, versus 24% for the S&P 500 and a 28% median for all U.S. equity funds.
• Investment style. The vast majority of the above-market performers espouse an intrinsic value
investment approach; they seek stocks with prices that are less than their value. In his famous
“The Superinvestors of Graham-and-Doddsville” speech, Warren Buffett argued that this
investment approach binds many successful investors.
• Geographic location. Only a small fraction of high-performing investors hail from the East-coast
financial centers, New York or Boston. These alpha-generators are based in cities like Chicago,
Salt Lake City, Memphis, Omaha, and Baltimore.
Based on our S&P scouting report, these managers seem to follow the index’s strategy with regard to
turnover and limited time on macro forecasting, and deviate from the index’s strategy with regard to
concentration and a sharp focus on price-to-value discrepancies.
We are not suggesting that all investors should or can embrace the approach of this group. A broad
ecology of investors comprises a well-functioning market. The market needs investors with varying
time horizons, analytical approaches, and capital resources. And many money managers have seen
outstanding results pursuing very different strategies than the ones we describe.
Further, it is worth underscoring that the success of these investors is not the result of their portfolio
structure (an outcome) but more likely reflects the success of their investment process. We once
overheard an investor remark to one of these superior performers, “You can have low turnover
because your performance is so good.” At once, the manager shot back, “No, our performance is
good because we have low turnover.” It would be futile to try to replicate the portfolio attributes (i.e.,
low turnover, relatively high concentration) without an appropriate process.
That noted, we still must ask the obvious question: Why is the profile of an average fund so different
than these superinvestors?

Investing Profession versus the Investment Business

Part of the answer lies in the tension—and perhaps growing imbalance—between the investment
profession and the investment business. The investment profession is about managing portfolios to
maximize long-term returns, while the investment business is about generating (often short-term)
earnings as an investment firm. There is nothing wrong with having a vibrant business, of course, and
7
indeed a strong business is essential to attracting and retaining top talent. But a focus on the
business at the expense of the profession is a problem.
A historical perspective of the mutual fund business suggests a strong swing to the business side.
One person uniquely qualified to document the industry’s changes is the legendary Jack Bogle, who
over the past half century has been an industry advocate, visionary, and gadfly. Here are some of the
8
profound changes Bogle notes:
• The number of common stock funds has swelled from 75 in 1949 to 4,800 today, and offer greater
specialization as well as geographic scope. The number of new stock funds the industry created
(as a percentage of those in existence) reached a record of nearly 600% in the 1990s, up from
about 175% in the 1980s. Notable, too, is that 50% of funds failed in the 1990s, and almost 900
have failed in the past three years alone.

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 • Competition leads to margin compression in most industries. But mutual fund expense ratios,
which averaged about 90 basis points in the late 1970s and early 1980s, have been rising
steadily over the past 15 years and now stand at 136 basis points. We can attribute a good part
of the fee increase to asset gathering costs. And costs matter: from 1950-1970, funds generated
returns that were 87% of the market’s. From 1982-2002, that ratio was 76%.
• Until 1958, the SEC restricted sales of management companies. After the courts struck down
the SEC’s position, the investment management industry saw a flurry of initial public offerings
and M&A activity. Of the 50 largest fund organizations today, only six are privately held. Seven
are public independent companies, U.S. financial conglomerates (23), foreign financial firms (7),
and major brokerage firms (6) own the rest. One mutual remains—Vanguard.
• One non-obvious consequence of active mutual fund marketing, as well as investor proclivity to
invest in the latest hot performing funds, is that the average fund performance has no
resemblance to actual investor returns. The reason is that investors pile into where the
performance has been, and inevitably suffer as returns revert to the mean. For example, growth
stocks saw their greatest quarter of net inflows ($120 billion) in the first quarter of 2000,
coincidental with the Nasdaq’s peak, while value funds suffered significant outflows. Bogle
calculates that while the market rose 13% from 1982-2002, the average fund return was 10%,
but the average investor return was only 2%.
Charley Ellis draws up a list of initiatives an investment firm might pursue to maximize its value as a
business. We summarize these in Exhibit 2. Ellis points out that the crux of the tension between the
profession and business is that they operate at different rhythms. Long time horizons, low fees, and
contrarian investing are good for the profession. In contrast, short time horizons, higher fees, and
selling what’s in demand are good for the business.

Exhibit 2: Pointers to Make an Investment Firm a Business

! Increase the number and enhance the stature of relationship managers, because whatever the
performance, they’ll be able to keep clients longer—and retention is key to profit maximization.
! Charge relationship managers with explicit responsibility for cross-selling more and more asset classes and
investment products to each client—to maximize “share of wallet” with each account.
! Expand the number and improve the industrial selling skills of sales professionals.
! Develop your organization’s “brand” or market franchise.
! Expand into new markets—at home and abroad.
! If you are strong in retail, expand into institutional. And if strong in institutional, expand into retail.
! Focus on mastering relationships with investment consultants, those powerful intermediaries who are
involved in 70% of all institutional manager hiring.
! Extend your firm’s product line into new asset classes and into all size variations—to diversify your
business risk of dependence on superior investment results.
! Limit the business risk of unexpected short-run investment results by hewing close to the index.

Source: Charles D. Ellis, “Will Business Success Spoil the Investment Management Profession?” The Journal of Portfolio Management, Spring 2001, 14.

So what should investment firms do? Ellis says it well:

The optimal balance between the investment profession and the investment business needs always
to favor the profession, because only in devotion to the disciplines of the profession can an
organization have those shared values and cultures that attracts unusually talented individual
9
professionals.
We would argue that many of the performance challenges in the business stem from an unhealthy
balance between the profession and the business. Many of the investment managers that do beat
the market seem to have the profession at the core.

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 1
Charles D. Ellis, “Will Business Success Spoil the Investment Management Profession?” The
Journal of Portfolio Management, Spring 2001, 11-15.
2 th
Appendix 1 in Benjamin Graham, The Intelligent Investor, 4 Edition (New York: HarperCollins,
1985), 291-301.
3
Burton G. Malkiel, “The Efficient Market Hypothesis and Its Critics,” Journal of Economic
Perspectives, 17, 1, Winter 2003, 78. This is not a new finding. See also Burton G. Malkiel, “Returns
from Investing in Equity Mutual Funds 1971-1991,” Journal of Finance, 50, 2, June 1995, 549-572;
Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945-1964,” Journal of
Finance, 23, 1968, 389-416.
4
http://www.ifa.tv/Media/Images/PDF%20files/SP500_Rules_GeneralCriteria.pdf.
5
Special thanks to Gary Mishuris for creating the initial list and prompting this line of inquiry.
6
Jack Bogle, using John Maynard Keynes’s terminology, contrasts speculation (“forecasting the
psychology of the market”) with enterprise (“forecasting the prospective yield of an asset”). Bogle
argues that the turnover ratios suggest most investors are speculators. See
http://www.vanguard.com/bogle_site/sp20030114.html.
7
See Ellis for an excellent exposition of this tension.
8
Bogle. See http://www.vanguard.com/bogle_site/sp20030114.html. Also, see “Other People’s
Money: A Survey of Asset Management”, The Economist, July 5, 2003 and John C. Bogle, “The
Emperor’s New Mutual Funds,” The Wall Street Journal, July 8, 2003.
9
Ellis, 14.

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