When selecting a manager, most people start, logically enough, with the returns. That is the money manager’s product, after all. But all too often the disclosure that past performance is no guarantee of future returns seems to be more of a prophecy than a warning. When you are looking at managers and you find one that has a very good long-term track record and has been producing good returns for the last two or three years, there is good news and bad news. The good news is that the manager has a style that produces good returns when that style is in favour. The bad news is that styles rarely stay in favour for longer than two or three years, so the manager is probably due for some underperformance. So you need other things to look for in deciding whether the manager will do the job for you longer term. Look at the returns, by all means, but look at other things as well.
Fortunately there are a number of tell-tale signs of a superior investment management firm, the kind of firm you can rely on for the long term. These characteristics can give you confidence that you have selected the right money manager, even when the manager is going through a tough performance patch. And that is going to happen. The only managers who produce truly reliable, predictable returns data tend to be the ones who are making it up, like Bernie Madoff.
My starting point was to try to think of the best possible money management situation and go from there. What would be the ideal situation for the investment of your family wealth if you had started a generation ago and what lessons can we learn from that experience?
The answer I came up with was that if you had invested with Warren Buffett in his company, Berkshire Hathaway, 35 years ago, you would have had something close to the ultimate money management experience. If you had treated him as your trusted family advisor for money management matters, and never fired him, you would have a very high level of satisfaction.
The most obvious reason for your satisfaction would of course have been the returns, since you would have made 200 times your money. I think it’s pretty unlikely you’ll find another situation like that. But I think of returns in this area much like the compensation we expect from our jobs. They are very rarely the sole basis of satisfaction in the relationship with the money manager, just as your salary is not the sole basis of satisfaction in your job. And as in compensation matters, when expectations are too high, disappointment and poor decisions tend to follow. In my experience, as long as clients feel they are being treated fairly as far as returns are concerned, they look for satisfaction in other ways from the money manager relationship.
So what would be the other sources of satisfaction from investing in Buffett’s company? I have identified seven, the first of which I discuss below, and I will touch on the others over the course of the next few blog posts.
First of all, you always know that Buffett has all of his net worth invested right alongside you. He, like you, is a shareholder of Berkshire Hathaway and that is the overwhelming majority of his personal fortune, over 90%. This is important because it means that his risk profile and yours are the same. In a lot of cases, especially “2 and 20” hedge funds, the money manager can benefit disproportionately from taking risks with your money. Those gambles give him big payoffs if they work, while giving you all the downside if they don’t. Beware of these situations! Asymmetrical risk/reward is not a good basis for a financial relationship.
Alignment is really important. I was once at a meeting where a client asked a money manager (not one of mine) what he personally invested in. The manager responded that he invested in penny stocks and ponies. We all laughed, but the client was not impressed, and justly so. The correct answer, always, is that you are invested alongside the clients, and that those investments constitute a good portion of your net worth. In my case, I have over 90% of my investable assets in Burgundy pooled funds. I tell my young people that life doesn’t give you too many opportunities to take unassailable moral positions, and you should take them when they are available.
You have the right to ask your money managers these questions. If they say they are invested alongside you, you should make sure they have a substantial investment – it’s not enough for them to put a few thousand dollars in your mandate and say they are aligned with you.
The Bible says that where your treasure is, there will your heart be also. Hold your money manager to this standard.