In yesterday's reading list, we included a recent New York Times piece on Legg Mason's Bill Miller, the renowned fund manager whose flagship fund beat the S&P 500 for 15 consecutive years, from 1991 through 2005.
The story's premise--that Miller has been chastened a bit by his fund's recent underperformance--is fascinating enough as a study in manager psychology. More interesting (to us, anyway!) is the fact Geraldine Fabrikant's piece features a few arguments that we've made repeatedly in this space.
First, there's the big picture phenomenon of reversion to the mean. In relatively efficient markets, it's just enormously difficult to sustain significant departures from the performance of a fund's underlying asset class. Many efficient-market absolutists will suggest that Miller's successful run may well have been little more than coin-flipping luck. With so many managers in the field, they might say, a small number of coin-flippers will come up heads 15 times in a row. We think there is such a thing as investment skill, often more temperamental than technical. But we fully acknowledge that luck is part of the game as well, and we suspect Miller was both good and lucky for many years. There's no reason to suspect he's any less skilled now than he was five years ago, but his randomized draws from the bag full of luck has clearly turned against him.
SOME longtime market experts think that fund size is the most daunting challenge he faces. Regardless of periodic ups and downs, he may simply be managing too much money to continue to produce outsized gains, they say.
"The number of investment opportunities just shrinks radically" when a fund swells, says John C. Bogle, the founder of the Vanguard Group, the mutual fund powerhouse, who describes himself as a fan of Mr. Miller. "The bigger you get, the fewer the number of stocks you can hold with a meaningful position."
Indeed, Mr. Miller holds a relatively concentrated portfolio, and the bad news has kept coming for some of his major picks. Last week, after Microsoft's proposed buyout of Yahoo fell apart, Yahoo's stock plunged 11.5 percent last week. Legg Mason holds a 6.7 percent stake in Yahoo. Countrywide Financial, another big holding, has been slammed by the mortgage crisis and errant lending. Its stock has fallen 87.9 percent over the last 12 months. And Mr. Miller amassed a sizable position in Bear Stearns, the investment bank gone to the grave.
We remember one of Miller's annual letters in which he freely acknowledged the constraints of running a portfolio that was at once enormous and highly concentrated. (He was aware of the problem then, but, in Fabrikant's telling, seems to dismiss it as a cause of his recent underperformance.) Because asset bloat is a structural problem, there's not much he can do about it, unless he diversifies his holdings. Which he and his team appear to be considering:
At Legg Mason, Mr. Miller has been stress-testing his investment theses -- the way he and his colleagues picks stocks -- and is considering a move away from concentrating his bets on dozens rather than hundreds of stocks.
"The question we are asking ourselves is: Should we think more broadly now about probability, about high-impact events and protecting against them by having broader exposure to the market?" he says.
Which leads us to the third point: Chasing "hot" managers is not a particularly wise game, at least not after they're both hot and pretty much universally recognized as such. Paying managers to pick positions and manage risk actively isn't inherently unwise, but it should be done with great care, and such services should be delivered in products and programs that have a relatively high probability of delivering what investors are paying for. There can be no guarantees, of course, but piling into enormous funds with a relatively high likelihood of mean-reversion strikes us as an approach that makes a difficult game that much harder.
Geraldine Fabrikant, "Humbler, After a Streak of Magic," New York Times, May 11, 2008