- Fred Schwed Jr. “Where Are the Customers’ Yachts?”
People often ask me questions such as “why didn’t you buy more of Acme Rubber Band stock when it dropped by 50% then rebounded 300%?”. Conversely, it might be a question about why I didn’t sell a stock that has risen a great deal but then dropped back in price. Many times my immediate response is to shout back - in my best David Mitchell impression - quoting Benjamin Disraeli “it’s much easier to be critical than correct!”. Frankly, that type of response rarely works well. So - in my own tedious and rambling way - I try to take the time to explain the cause for my actions. My gut feeling is that this type of response garners as little excitement from the questioner as it does me. When I’m taking to an individual investor, it sometimes seems like we are speaking different languages.
Professional Money Management: Different Needs, Different Goals
I must concede the stock selection methodology, selection criteria, and emotional responses are usually quite different between a professional money manager and an investor managing their own money. As an investment manager myself, what investments I select, why I select them, and even how I purchase them is very different than if I was choosing my own personal investments. Much like Mr. Schwed’s virgin, there are some things you simply can’t describe in a case study or colorful graphics. There is a very particular feeling when you lose 55% of your client’s investment portfolio on a particularly bold bet on a Rumanian bakery company. For those who think it’s painful to lose your own personal investment dollars, wait until you start losing other peoples’ money who pay you to fund their retirement or their child’s college education.
I was recently talking to an individual who manages his own family’s investment portfolio. It is roughly $50 million dollars with the bulk of it made by the sale of the patriarch’s privately-held construction company. He told me he enjoyed reading my articles and book, but said he couldn’t see much difference between what he does and what I do as an investment manager. One thing that struck me right away was that it certainly feels different managing other peoples’ money versus my own. After giving it more thought, I thought my readers (and my friend) might find it interesting to see how we see the distinction here at Nintai Investments.
Regulatory is a Whole New World
The first difference – and certainly the most profound – is the amount of regulatory requirements necessary to create and run an investment advisory business. It boggles the mind to see the sheer volume of state and federal regulations that dictate everything - from how you market your services to how information you are allowed to disclose to different people. There is no amount of discussion or graphic demonstrations that can prepare a fresh college graduate who thinks they can quickly open up their own investment house.
Your Fiduciary Responsibilities Lie With Your Client
The Investment Company Act of 1940 along with the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, are make up the rules-based regulatory backbone issued by the Securities and Exchange Commission. In addition, each state has its own Securities Division – usually residing in the Secretary of State’s office. Both Federal and State rules and agencies are designed to protect the general investing public. For the individual investor, you will likely see all of these efforts is in a mound of paperwork you (if you are the average investor) will never read. As an investment manager, these regulations are there to modify your thinking from an internal perspective (you as a money manager) to looking outwards (for your client). You can never lose sight of the fact that you are a fiduciary steward for your clients.
Even Though the Fiduciary Rule is Dead, Its Ghost Lives On
During the Obama administration, the Department of Labor proposed that investment advisors act in their investors’ best interests in managing their retirement accounts. It became known as the Conflict of Interest Rule. The proposed rule would have meant shifting away from commissions on various investment products and becoming completely transparent on what advisers did and the advice they would provide. Inexplicably (or maybe not), there was a great deal of hostility towards the proposed rule leading to multiple law suits, congressional hearings, and bombastic op-eds. Apparently, the horror of putting your clients fiduciary needs ahead of your second vacation home was simply too much for the industry and it was quietly put to sleep in June 2018.
It Doesn’t Meet Our Investment Partner’s Needs
As a registered investment advisor, I have a fiduciary responsibility to purchase investments that best meet my investment partners needs and style. For instance, they may state they want no tobacco or gun companies in the portfolio. As a 70-year old retiree it is likely (but not certain) to be a bad investment choice to allocate 25% of all assets under management (AUM) in high-tech stocks with no earnings, no free cash flow, and a rapidly evolving product space. The simple case may be that – while Acme Rubber Band Company makes sense in my 12 year old nephew’s IRA – it has no place in my client’s portfolio.
It isn’t just process that separates investment managers from individual investors. Many times individual stocks are not in portfolio because of specific market conditions, the amount publicly floated shares, or trading volume. For instance, in my investment search criteria, there are only 125 – 150 stocks that meet my investment criteria. As my assets under management continue to grow, it becomes increasingly hard to obtain adequate shares. Two issues can become problematic in these cases.
The Position is Too Big as a Percent of Total AUM
As an individual investor, I didn’t get overly concerned when a portfolio might represent more than 40% of my total investments. This is certainly different than my role as an investment manager. Currently we have a rule that when a holding exceeds 10% of total AUM we notify our affected investment partners. At 20% a second letter goes with a detail risk analysis. We have a hard cap at 30%. Does this decrease my chances at watching a stock become a ten-bagger like FactSet Research (FDS) became earlier in my career? You bet. But does it allow our investment partners a greater level of comfort? Indeed it does. I’ve always held true to the idea that if I lose a point or two to achieve a good night’s sleep then I will unhesitatingly do so for myself and my clients.
It Takes Too Long to Acquire/Sell the Total Position
We have a holding in all the portfolios we currently manage – Biosyent (OTC: BIOYF). It is Canadian company traded on the Toronto Exchange under the ticker RX. We own shares purchased in the over-the-counter market. On any given day, it might trade 7,500 shares on average. In our current positions, we own roughly 13 days of trading, meaning it would take 13 days of average activity to fully liquidate our total holdings. As stewards of our investors’ capital, this is a risk we take quite seriously. With roughly 20% of each portfolio in cash and long-term buy and hold investors, we are comfortable with this type of situation. But one doesn’t have to think very hard about risk if we levered up on this position by purchasing an additional 50% on margin.
You Actually Need a Great Return History
Everyone talks a good game on internet chat boards or in the comments section of some Seeking Alpha article. When you become a money manager, you lay everything out there for your clients to see. Everything from your management costs to sales agreements to your actual returns. There are no mulligans and there is no selective grooming of the portfolio to scrub out the occasional bone-headed investment decision. In essence, managing other people’s money means you open your kimono and compete every day against your appropriate benchmark and other investors who are likely a lot smarter than yourself. After all that, you have to create a compelling record - either through your own investment methodology, a particular niche that you know better than others, or simply pick great stocks that outperform over the long-term. Having that record - and having it audited and confirmed by third parties - is far more difficult than most people think.
Playing With Your Money or Someone Else’s Money
A final note on managing your own money versus someone else’s. If you think the latter gives a greater level of risk, or it gives you a chance to stretch returns and make you look real smart, you are in the wrong business. Fiduciary responsibility is a remarkable honor to have bestowed on you, but it comes with great responsibility. From both an ethical and legal perspective you have the responsibility to do what’s best for your client. In many cases, this might be at odds with what’s good for you. Much like Mr. Schwed’s virgin and investor, you can’t teach someone how it feels to lose a substantial amount of money in the markets. It certainly can’t teach you what it feels like when it’s your clients’ hard earned savings. Generally, great investors are also great financial stewards. They weren’t taught that. It’s likely the next generation of great investors won’t be either.
As always I look forward to your thoughts and comments.
DISCLOSURE: I own Biosyent in several personal and institutional accounts that I personally manage.
 A compilation of classic David Mitchell rants, ravings, and general outbursts can be found here.