Brace yourself, folks: A money manager is about to speak the awful truth.
Of course, mutual fund managers aren't a dishonest lot in general -- most seem like fairly straightforward, conscientious people. But you won't find many skippers who readily concede that the industry is riddled with problems that make index funds look most appealing.
Ted Aronson of Philadelphia-based asset manager Aronson+Johnson+Ortiz is one such rare bird -- but his frankness isn't the only trait that makes him unique among money managers. Aronson's firm also refuses to engage in "soft-dollar" deals with brokers that surreptitiously eat into investors' returns. In fact, he chaired a recent Association for Investment Management and Research commission that established "best execution" practices, or trade management guidelines, among fund firms. Further, Aronson's firm keeps fees low -- and pegs much of the fees that his firm collects to actual performance.
Last, as a manager for institutional clients such as
and the New York Fire Department Pension Fund, as well as fund investors via his
Quaker Small-Cap Value fund, he has managed to outperform fairly consistently -- rare indeed.
In this week's
, Aronson weighs in on a host of topics -- and as you'll see, he is big on full disclosure.
1. Why would you, a successful manager of actively managed money, tout the virtues of passively managed index funds?
There are three reasons why index funds make a lot of sense. First, this is a competitive ball game. The past three years -- I guess you could call it a melt-up, then meltdown -- have humbled everyone. It's a very competitive game and most don't measure up to the performance of the indexes.
Second, investors need to understand that what Wall Street is expert at is separating clients from their money. When the pie goes around, there are more fingers in it than the owners have any idea -- so expenses are amazingly substantial.
I'm not just talking about brokers, mind you, but loads and other fees, and the government, too. If we accumulate wealth, Uncle Sam is in for a cut. Put all the pieces together and
Vanguard founder John Bogle has it right: It's not easy to outperform.
Third, we're all human. We tend to do exactly precisely the wrong thing at the wrong time. I used to get exercised about it. I used to think people were stupid, now I realize they're just people.
We all fall prey personally to human nature. We finally buy
at $84 and decide to throw in the towel at $11. We can laugh, but it's true -- professionals and individuals alike.
When you put those three elements together, you realize that your best bet is to make your investments, lock them up and don't look at them for a good long time -- except to rebalance occasionally. Didn't Warren Buffett say his favorite holding period is forever?
2. Yes, and he also said in a 1996 Berkshire Hathaway report that for most investors, indexing is the right way to go. While you readily concede these points, your firm has outperformed fairly consistently. How have you managed to do so?
Yes, we have managed to outperform. If you throw in taxes, we lose some of that outperformance. And frankly, I've been doing this for almost 30 years, but even that isn't enough time to prove that it isn't just luck. We've all flipped the coins a lot of heads in a row.
3. Why, then, should anyone invest with Aronson?
If this conversation were taking place over a few drinks, I might be even more honest with you. (Laughs.)
Individuals should only invest in us and the Quaker Small-Cap Value fund if they're prepared to ride the roller coaster with up and down returns. I'm not even talking about absolute returns. I'm taking about relative returns. It is impossible to find a period that demonstrates that more than the past six years.
The peak on March 2000 was so damaging and punishing to value investors that it should always be remembered when people bet on a style or a manager's skill. So many value investors just gave up and tried to run with the bull market.
Those that gave up at that point got a double whammy --- crappy performance on the way up, and lousy performance on the way down. They didn't even get the upside when the bubble crashed.
Investors should prepare for the extreme realities of the stock market and have the discipline to stay the course, to use another of Bogle's pet phrases. If you can't, you shouldn't invest with us, you should be in index funds. It's no accident that GM and the other institutional clients we have also invest a sizable chunk of their assets in passively managed funds.
4. Why do you think so many individuals, then, have the mistaken notion that the so-called smart money is in actively managed funds, when the reality is that institutions have a greater percentage of their assets in passive funds from the likes of Vanguard and DFA?
I really don't know, but I definitely wouldn't say all institutional investors get it right. Some would say investment committees at these big institutions raise idiotic behavior to a power. The recent explosion in interest in hedge funds illustrates the point.
There's a reason Harvard's investment committee has dozens of investment firms working for it and has a triple-A rating. They have a fortune to invest. Can my mother follow that smart money? I don't think so. Why not? Again, think of precept No. 2 discussed earlier.
Now, Wall Street is telling investors, even you can get in on these red-hot hedge fund returns! These funds of funds. Oh, and how about a load, plus extra high management fees. Honestly, what's left for the client? Will returns be good? Probably, yes. What about after fees and taxes? Most likely not. But that's Wall Street for you -- always looking for new ways to separate you from your money.
5. This sounds distressing, like Glengarry Glen Ross. If Wall Street really does constantly find ways to separate us from our money, why do we keep returning to the table?
Hope springs eternal. That's why
Glengarry Glen Ross
stuff is always there.
Forgive the clich¿s, but we all think it's different this time. Money magazine's Jason Zweig recently wrote of an image that stuck with me since he first used it: The very nature of the "revolution in investing" that has occurred over the past few years has allowed investors to pick their own pockets. This isn't just referring to hyperactive Internet trading, but the ability to, at the speed of electrons, get returns out there and momentum out there. We've created a situation where investors can now pick their own pockets, thanks to excessive trading and the like.
6. Let's talk about some potential solutions. What did the AIMR committee you chaired develop to remedy the damaging effect of high fees?
I was very fortunate to be chairman of the committee, and very happy to be involved in developing trade management guidelines for the investment industry. It was originally called "best execution" guidelines, but nobody could agree what constituted the best execution so we went with trade management guidelines.
I am convinced that it isn't lost on the
Securities and Exchange Commission
that the preeminent professional organization of money managers and analysts have come up with what we think are best management guidelines.
The interesting thing about our guidelines: There is absolutely nothing new on the list. It simply codifies and lists everything. Of course, you would think every industry would know to tell clients what you're doing with their money, and conflicts of interest that exist. But our industry hasn't done that yet.
The committee spent a lot of time on trading and transaction costs. What we learned is trading is a process, not just an event. If I'm George Soros and I'm going to make a bet against the pound, the process of executing trades is quite different than if I manage an index fund. But we think we have developed a firm set of guidelines and, knock on wood, I think the SEC will adopt them. Hopefully, they're not going to waste time, they'll simply rely on our checklist.
For the first time, with a little help from
former SEC Chairman Arthur Levitt and
current SEC Chairman William Donaldson, people are asking, "Why are trades costing 5 or 6 cents instead of less than a penny? For the first time since May Day 1975
when soft-dollar commissions replaced fixed commissions as the form of compensation between money managers and broker-dealers, you're seeing some real cracks in the dyke.
7. I realize no one has a crystal ball, but how long will this process take?
Well, I'll offer a close but inexact analogy.
Can you believe that our industry didn't have established standards for presenting performance until the past decade? Even the best funds had a composite performance number. It took a good decade, half a generation to implement real changes in the form of Global Investment Performance Standards, or GIPS, an acronym
that everybody seems to forget what it stands for.
When GIPS first came out, we were in the great bull market, so few people paid much attention to implementation. Given the current market and reformist environment, we hope the trade management guidelines take hold sooner.
8. Should investors even wait for white knights in Washington to sweep in and reform everything?
Make no mistake: The pressure has got to come from the clients -- the money.
The individual investors -- the odd lot, as we used to call them -- can best serve themselves and the reform efforts by voting with their wallet. Go to the people that give you a fighting chance, the Vanguards and DFAs and other low-cost money managers who look out for your interests.
9. It has been estimated that more than 90% of money managers engage in soft-dollar commissions in one form or another. Why doesn't Aronson, and how have you been able to thrive without them?
Please don't think I think I'm smarter than other money managers on the issue of soft dollars. Every money manager worth his salt knows that economical trading is important.
In a way, we were lucky. Back when we started in Aronson in 1984, we just decided we would clear the decks of anything conflicted and stay above board.
Was the appeal of soft dollars tempting? Oh, yeah. You can use soft dollars to pay for
. We could've booked tens, hundreds of thousands of moolah. When institutional crossing
electronic-communication trading networks was invented in 1987, we learned we could twist it and use it for our own active trading. Since we didn't engage in soft dollars, our costs were low. So, here we are, because of our dumb decision to play it straight. Plus, I realized we get the additional benefit of being able to say to clients, "No soft dollars here! Never have, never will."
Look, we don't think we're better than a
. But the low estimate on the cost of soft dollars is $1 billion. That's a big slush fund. Add in 12b-1 fees and other stuff, you're talking about $10 billion. That's a big number.
Why do others use it? I think it's obvious.
10. OK, let's save one question to actually discuss the fund you manage. Would you explain the investment philosophy behind Quaker Small-Cap Value and how you've managed to succeed?
Quaker Small-Cap Value is what I would call an eclectic value fund. We are supersonically diversified and sector-neutral to the small-cap market.
Our fee structure is also unique: We are paid a fee based on our actual outperformance. Performance-based fees are a very unpopular form of compensation. To the credit of Fidelity Magellan and Vanguard Windsor funds, they base fees on performance as well. But the vast majority of funds aren't willing to do it.
Out performance-based fees operate in a symmetrical fashion above and below the standard fee. So, our Quaker fee ranges from 30 basis points to 150 basis points, a symmetrical swing of 60 basis points around what the SEC calls a fulcrum rate (our fixed standard fee of 90 basis points. We are now being paid the maximum because we've outperformed our benchmark handily. If we underperformed, our fee drops to 30 basis points.
One other note: All the partners at Aronson are invested in Quaker, so when the fund wins, we win.