John Maynard Keynes once sarcastically likened professional investment to a newspaper competition in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.
Under the circumstances, each competitor, wrote Keynes, will pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom will be looking at the problem from the same point of view.
It is not a case, wrote Keynes, of choosing those which, to the best of one's judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. Rather, we have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.
Many decades have gone by since those words were written, but investment, as practised by many mutual funds and other "professional" investors remains unchanged.
Over the last two years, most Indian mutual funds have performed dismally as compared to market averages. The Indian investor, in aggregate, has not got his money's worth by hiring "professional" investors to manage his money.
While there are several reasons offered for such dismal performance, the most convenient one for mutual fund managers, and therefore, the most cited one is that the market is down. The objective of this article, however, is not to go into this issue. Rather, my objective is to highlight an important point that has not been made by the financial press while conducting the post mortem of several Indian mutual funds. And that point, keeping Keynes metaphor in mind is this: If you buy the same stocks as everybody else, you will have the same results as everybody else.
Different Funds, Similar Portfolios
If one goes back two years, when the market was booming, and checks out the annual reports of most Indian mutual funds, one would find an interesting fact. Almost all mutual funds had very similar portfolios. In fact, it was hard to find a mutual fund that did not have three large and popular stocks in its portfolio - Reliance Industries, ITC and Tisco. Incidentally, even though one organisation may have promoted several mutual funds, some of them advertised as income schemes and other as growth schemes, these three popular stocks selling at correspondingly "popular" prices were included in the top ten holdings of all the mutual funds promoted by such organisations.
Ralph Wanger's Zebras
Ralph Wanger is an outstanding mutual fund manager in the U.S. He manages two mutual funds - The Acorn Fund and The Acorn International Fund. In both funds Wanger has outperformed the market by a large margin. In case of Acorn Fund, $10,000 invested in June 1970 had grown to $575,000 till June 1996. If that money, had been invested in the Standard and Poor's 500 index, it would have grown to only $249,970. In case of Acorn International fund, $10,000 investment made in 1992, had grown to $19,500 till June 1996. If that money had been invested in EAFE index, it would have grown to only $15,965.
Wanger has made money for his clients by shunning popular stocks and by looking for hidden value in small and unknown companies that other institutional investors don't even look at.
Wanger's letters to his investors in the annual reports of both the funds managed by him are collectors items, much like the Warren Buffett's letters contained in the annual reports of Berkshire Hathaway - Buffett's investment vehicle. Over the years, Wanger has made some hilarious comments on professional investors who like to move in herds. In one annual report, he compared institutional investors to zebras. Here is his description of typical institutional investors, a description that applies equally well to many Indian mutual fund managers:
"Zebras have the same problems as institutional portfolio managers. First, both seek profits. For portfolio managers, above-average performance; for zebras, fresh grass.
Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions.
Third, both move in herds. They look alike, think alike and stick close together.
If you are a zebra, and live in a herd, the key decision you have to make is where you stand in relation to the rest of the herd. When you think that the conditions are safe, the outside of the herd is the best, for there the grass is fresh, while those in the middle see only grass which is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better.
On the other hand - or other hoof - there comes a time when lions approach. The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well but they are still alive.
A portfolio manager for an institution such as a bank trust department cannot afford to be an Outside Zebra. For him, the optimal strategy is simple: stay in the centre of the herd at all times. As long as he continues to buy the popular stocks he cannot be faulted. To quote one portfolio manager, "It really doesn't matter a lot to me what happens to Johnson & Johnson as long as everyone has it and we all go down together." But on the other hand, he cannot afford to try for large gains on unfamiliar stocks which would leave him open to criticism if the idea fails."
Needless to say, this Inside Zebra philosophy doesn't appeal to us as long-term investors.
We have tried to be Outside Zebras most of the time, and there are plenty of claw marks on us."
Ben Graham's Oil Prospectors
Over the years, Warren Buffett has criticised the way most institutional portfolio managers manage billions of dollars of investors' money. After the 1987 stock market crash in the U.S, Buffett made this comment about institutional investors:
"We have "professional" investors, those who manage billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like thimble and flatiron in Monopoly."
On another occasion, Buffett quoted his mentor Benjamin Graham who told a story many decades ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. "You're qualified for residence", said St. Peter, "but, as you can see, the compound reserved for oil men is packed. There's no way to squeeze you in." After thinking for a moment, the prospector asked if might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, "Oil discovered in hell." Immediately the gate to the compound opened and all of the oil men marched out to head for nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. "No," he said, "I thing I'll go along with the rest of the boys. There might be some truth to that rumour after all."
Peter Lynch's Comments
Peter Lynch, another outstanding mutual fund manager who has made billions for dollars for his clients by buying stocks no other institution was interested in has also criticised the typical behaviour of institutional investors.
"Between the chance of making an unusually large profits on an unknown company," says Lynch, "and the assurance of losing only a small amount on an established company, the normal mutual fund manager would jump at the latter. Success is one thing, but it's more important not to look bad if you fail. There's an unwritten rule on Wall Street: You'll never lose your job losing your client's money in IBM.
If IBM goes bad and you bought it, the clients and the bosses will ask: "What's wrong with that damn IBM lately?" But if La Quinta Motor Inns goes bad, they'll ask: "What's wrong with you?" That's why security-conscious portfolio managers don't but La Quinta Motor Inns when two analysts cover the stock and it sells for $3 a share. They don't buy Wal-Mart when the stock sells for $4, and it's a dinky store in a dinky little town in Arkansas, but soon to expand. They buy Wal-Mart when there's an outlet in every large population centre in America, fifty analysts follow the company and the stock sells for $40."
Conclusion
The real reason for the dismal performance of most Indian mutual funds is not that the market is down but that the personal gain/loss equation of mutual fund managers is not the same as that of their clients. Mutual fund managers just don't have the incentive of making an intelligent-but-with-some-chance-of-looking-like-an- idiot decision. If an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get fired. If such is the case what stocks do you think they will choose? They will choose the "safe" Reliances, ITCs and Tiscos remembering these words of Keynes: "Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally."
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited.
© Sanjay Bakshi. 1996.