It was almost a Damascene moment. In a wide-ranging and thought-provoking interview with The New York Times last month, Bill Miller, chairman of Legg Mason Capital Management, made the following comment. "The question we are asking ourselves is: should we think more broadly about probability, about the high-impact events and protecting against them by having broader exposure to the market?" The article does not give this comment any special prominence. But for the fund management industry it is a prognostication with profound implications.
For those unfamiliar with Miller or the current situation at Legg Mason, a little context is necessary. Miller built his formidable reputation as a fund manager by beating the S&P500 for 15 consecutive years between 1990 and 2005. It is a track record that is second to none. Moreover, it was built with pure stock-picking acumen. His typical portfolio held fewer than 40 names. Miller was blowing a big fat raspberry at the efficient market hypothesis year after year. He was the champion of active fund managers everywhere and rightly so – he justified their existence.
More recently, however, things have turned sour. Miller has not beaten the index in the past two years and the first quarter of 2008 was his worst ever. His flagship fund, Value Equity, trailed the S&P500 by more than 1,000 basis points. The fund fell in value from $17 billion to $12 billion. In addition, net redemptions from other funds and turmoil in credit markets dragged Legg Mason Inc to its first ever quarterly loss.
Against that backdrop it was brave of Miller to give the interview at all and it is no surprise that he is searching for answers. But to recant his faith in focused stock-picking will strike many true believers as nothing short of apostasy. That would be a harsh judgment. He chairs a company and manages a fund enduring a very rough patch. Only the most overweening fool would not take time to pause and take stock. The issue he raises is also far bigger than the Value Equity fund or Legg Mason.
What Miller was hinting at was a lurch towards an investment approach followed by many mainstream money managers. In a world where outperforming the S&P500 can turn the manager into a star, a mutual fund into a behemoth and an investment company into a profit machine, what is the best way to do that? Miller thought he had found the answer. Now he is less sure. By moving to a more diversified portfolio he might still outperform by a little bit and he is also less likely to underperform by a lot.
That makes sense for the career of the individual manager and for the business. This managed mediocrity is, in fact, what many mainstream money managers do. It makes sense. Or it did until those pesky hedge funds turned up with their promise of alpha. What is particularly galling is that hedge funds have the deck stacked in their favour. For one thing they can short, which creates more efficient portfolios if they have skill. Also, they have lock-ups, which mean hedge funds can practise precisely the sort of long-term, patient money management that Miller is rightly famed for.
The biggest advantage that hedge funds have is their business model. If you are running a $2 billion long/short hedge fund, charging 2% management fees and garnering 20% of the outperformance, life is sweet enough. Pity poor Legg Mason, a publicly quoted company, with a responsibility to grow revenues for shareholders and thus assets under management. It might be that Bill Miller is still the most skilful stock-picker in the US, but the weight of managing tens of billions crushed him. A 35-stock $17 billion fund is de facto a large-cap fund and moving those positions is going to cause tectonic market impact.
Later in the interview, Miller changes his mind about the wonders of diversification. "I have never found it a useful policy because what it guarantees is that you will be in the worst sectors of the market as a matter of policy. That is why so many managers are justly criticized as closet indexers because they don’t get too far from the index because they are afraid to be wrong. My view is that being wrong is part of the business. You need to focus on making the best investments you can, instead of trying to smooth things out."
Active managers everywhere will breathe a sigh of relief. If Bill Miller had given up on skilled stock-picking their number would be up too. But even this brief flirtation with closet indexation revealed how fundamentally challenged traditional long-only asset managers are by the separation of alpha and beta. For clients unwilling to accept exorbitant fees and lock-ins, it is hoped Miller’s perseverance is rewarded and emulated. Skill is hard to find in fund management, full-stop. There are still long-only stock pickers who have it.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own