The Rules, Part X

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.  This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

I was at a conference on Stable Value Funds, I think around 1995.  The meeting hadn’t started  but a few attendees  had arrived.  We were talking about the need to find yield in the market when one said (with an arrogant attitude), “Yield?  Why not total return?”

A tough question, and one none of us were ready for at the time.  My thoughts a few days later were on the order of, “If only it were that simple.  Right, you can generate positive returns over every time horizon worth measuring.  Okay, Houdini, do it.”

Total return investors don’t have long time horizons.  Investors with short time horizons either aim for momentum plays, or aim for yield.  Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

Yield is less volatile than momentum, at least most of the time.  But yield is a promise, and frequently disappoints during times of stress.  Look at all of the dividend cuts over the past two years.

But consider this from a different angle.  Imagine your boss comes to you and says, “I want you to deliver the best returns to me every day versus the S&P 500.”  Okay, beat the S&P 500 every day.  That means the portfolio has to be a lot like the S&P 500, with some tweak that will beat it.  Anything too different from the S&P 500 will miss too frequently.

Now, I would say loosen up, why constrain daily performance?  Aim for great returns over the long haul, and don’t sweat years, much less days.  Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run.

Those with short horizons will tend to index relative to their funding need, whether it is cash, short bonds, or indexed equities.  Note that most managers should have long horizons, but clients evaluate the returns of the past quarter or month, and the manager feels as if he is on a short leash, which makes him look to the next month or quarter, and makes him invest more like an index.


If you have a good manager, set him free — lengthen the performance horizon; give him room to do things that are unorthodox.  Ignore the consultants with their foolhardy models that constrain manager behavior.  Let me tell you that you are brighter than the consultants, and can better manage managers than they do.  Their models encourage managers who hug the indexes to avoid doing too much worse than them, and so you get index-like performance.


At turning points, a different breed of investor shows up.  At busts, investors show up who will buy and hold, bringing stability to the market.  They look at fundamental metrics and conclude that their odds of losing money are small.  At the booms, a different investor leaves.  They will sell and sit on cash.  Similarly, they think the odds of losing money, or, not making as much, is large.


Good money managers think long term, but all of the short-term measurements fight against that.  They force managers to think short term, or else their assets will leave them.  That is a horrible place to be.  Better that clients should ignore the consultants, and aim for the long-term themselves.  You will do much better choosing managers for yourselves and ditching the consultants who (it should be known) merely chase performance.  With help like that, you may as well invest in the hottest stocks with a portion of your portfolio — you might do better than you are doing now.


  • Jay Weinstein says:

    Good points as usual David. I have long felt that the creation of the benchmark concept has ruined the investment industry— shooting single mindedly at the target seems to inevitably cause you to miss it badly! Change your target depending on the circumstances works better in the long run.

    My investment mantra, quite successful over the past 25 years, has been “Don’t do anything stupid.” I refuse to be benchmarked to anything as long as I follow that rule :)

  • Burt says:

    I think you’re statement, “Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run,” begs the question of what really works over the long run? There isn’t a dataset that is truly robust enough to answer the question. From survivorship bias to double counting to data mining most long run datasets leave much to be desired. Hence, how can a rational manager have a sense of what works in the long run without making a leap of faith?

  • It is remarkable how the herd is forced closer to the index. I’d not thought before about how the desire to beat the index forces you close to it.

    I’m sure you have thought about some (or many) form(s) of this: accounting conventions are not only a window that affects our view of reality; they also shape reality. Neg-am mortgage pools could show both strong interest income and strong new lending, as the delayed interest was added to the principal, and this motivated more senseless lending. Generous layoff packages and future benefit promises often make no long-term sense, but may affect the current quarterly report positively, causing management to take decisions that harm the company (or the state). I’d be very interested to hear your comments on the general phenomenon.

    Jim Fickett

  • @Jay: Excellent! It may not be popular to say so, but most investors make a lot of really stupid decisions. Just not doing anything stupid puts you ahead of the pack.

  • Danny Black says:

    Surely for most people the goal should not be yield rather asset-liability matching.

    The point about fund managers is that it is demand driven. Your end-users want absolute returns so you have to deliver them. Your end-users DON’T have long term goals so you can’t have. Look at the boom, the people who were traditional value managers – and the ones who stayed honest – got killed.