By: Frank Armstrong, CFP, AIF
Long ago and far away, before Windows, before the Internet, and before Morningstar on disk, an almost young man was trying to decide what to do with the rest of his life. Things had gotten interesting. He had for years both flown for an airline and sold securities for a major broker dealer. But, his airline died an agonizing death simultaneously impoverishing almost all of his friends and current clients.
He had reached the proverbial fork in the road. Opportunities to continue flying were not attractive. On the other hand, he despised the broker dealer environment where the only ethic was “sell more”.
There is nothing like the threat of imminent starvation to focus one’s attention. It was time to get creative, or move under Miami’s Watson Island Bridge with the other “outdoorsmen”.
Just in time a revolution occurred in the securities business led by a visionary with an almost white hat. Charles Schwab launched an entire new industry by providing “back office” and custody services for fee-only independent advisors. He enabled professionals to provide truly objective advice free from the broker-dealer’s ever present conflicts of interest by breaking the link between advice and brokerage.
Schwab’s business model provided an opportunity to do the investment business the right way, working exclusively in the interest of clients. As a Registered Investment Advisor I could provide investment advice, continuous oversight, and asset allocation using no-load mutual funds. Each fund would be guided by the industry’s best managers. I would be a manager of mangers!
But, how could I identify these great managers? The easy answer was to simply take the top performing fund for the last five years in each asset class. But, there was a nagging problem. Suppose the manager had had one great year and four bad ones? The cumulative return might look good, but having one lucky year is not great management. A better approach seemed to be to take fund that had been in the top quarter of their asset class for each of the last five years. That would provide consistent top performance.
At first blush it seemed to be an easy task. Powerful personal computers and access to sophisticated databases had recently become available. We could download performance numbers from CDA/Weisenberger via a phone link at the amazing speed of 400 baud. In practice, that meant starting a download on Friday afternoon, and hoping that the system didn’t crash sometime over the weekend. In addition to long distance charges, there were separate charges for each file, computer connect time, and total download in bytes. In just under a month of false starts I had the data!
That was just the beginning of a long sequence of steps before we had anything useful:
- Purchase a relational database program. Paradox was the program of choice then.
- Learn to program Paradox. Unfortunately, all the instructions started out with the assumption that the reader understood “Basic” programming.
- Buy a Basic program from Microsoft
- Learn to program Basic
- Convert the text files to the database language
- Write a Paradox program to identify top quartile managers in each time period.
No problem. With no flying schedule and virtually no solvent clients, I had plenty of time. I took a mountain of programming books, the various programs, my luggable computer, the data, my new wife, and my boat to the Bahamas.
Between sailing, fishing, and scuba diving I still spent a solid six hours a day in the books. No kidding! After about a month of studying, watching the computer crash, watching the program crash, error messages, de-bugging, and re-writing I finally got the program to run without crashing. But, it just stopped and blinked at me. Another ten days of trying to figure out where the error was and I was almost crazy! Where, oh where could the program be wrong? I have no idea how many times I re-wrote the program only to have it stop cold with no result.
Then one night about three AM while half asleep at a snug anchorage, it came to me: My Eureka Moment! I levitated out of bed, fired up the generator, booted up the computer and sprang into action. At that point, my wife surely must have thought I had lost it.
It was all so simple. The program was right, but there was no error. There was just no answer. No manager in any asset class had ever been in the top quartile against his peers for five years in a row!
I relaxed the requirements incrementally to 30, 35, 40, 45, and 50 percentile. Finally at 55 percentile I got one hit in one asset class! It was even worse than I had thought. Not one manager had achieved even top half results against his peers for five years in a row in any of about 18 asset classes! Some asset classes were even worse! It was all BS (a highly technical pilot term)! Managers couldn’t add value consistently. There were no good managers! Not one! Not even one!
I was crushed. If there were no good managers, how could I be a manager of managers? What kind of business would that be? I returned to Miami with my tail between my legs to mope around the office. In pilot terms, I was out of airspeed, altitude and ideas all at once! A more relaxed life style camping out under the Watson Island Bridge looked like a distinct possibility. I consoled myself that no one actually freezes to death in Miami.
But, the story has a happy ending. After just a few days of feeling terribly sorry for myself, by pure chance along came a representative of an index fund family. As he started to talk about how difficult it was for managers to beat simple benchmarks, and how much risk and cost were generated in the pursuit of the impossible, slowly a little light went on deep inside my head.
Most of what I had been so carefully taught by the broker-dealers had been dead wrong. No wonder the results had been so distinctly mediocre. It was time for me to take responsibility for my own education if I was ever going to be effective in assisting clients.
The rest is history. I immersed myself in modern financial theory, catching up on what economists had learned about how markets work, and how investors can put markets to work to meet their own unique needs. It’s the market that generates the return. Traditional managers picking individual stocks and attempting to time markets just get in the way.
I built a business around the idea of using efficient markets to deliver effective portfolios that are low cost, low risk, and tax efficient. Informed investors can identify with those objectives. As I studied more I never encountered anything that shook my faith. I’ve never looked back.
Let me be frank, before my experience I would never have let an index fund representative in the office. Like most people I thought index funds were for losers, investors that were too lazy or incompetent to find one of the great managers. But, now I was ready to listen. I had had my Eureka Moment!