INTRODUCTION

A former colleague of mine used to say, “Whenever people lose a lot of money, they need to find scapegoats.” In our current financial crisis, it’s easy to point fingers at the so-called Wall Street “fat cats.” When there’s as much blame to go around as this, even the easy targets are reasonably worthy of the attacks thrown their way.

But to understand Wall Street’s true complicity in our troubles we need to dig a bit deeper. We need to go a level or two lower into the management ranks. In doing so, we will find something rather surprising, something that goes against the common notion of unimaginable greed run amok.

The development of finance as one of this country’s primary industries has created a subculture whose contradictions may prove amazing to outsiders. Far from a world of strivers and seekers, the industry is largely run by people who are paid very well but not on the order that makes headlines and causes contrived outrage in Congress. These are the “extremely comfortable” individuals making mid-six to low-seven figures—far more than the average person, but not the kind of money likely to spark protests and witch hunts.

Why am I focusing on this group?

In my experience, most of them do not seek excellence in their work. They don’t try to get things right—they simply don’t want to be obviously wrong. Knowing they are paid far better than they would be in any other career they might have, they cling with a strange viciousness to their jobs by creating and matching performance standards neither impressive nor wretched. They seek conformity, a sameness of outcome, behind which they can hide while collecting that extremely comfortable pay.

But here’s the rub. There’s no great harm in a single person trying to match the performance of a benchmark if that benchmark is generated in a world of otherwise independent-minded strivers. But if too many of them are seeking to match one another at once, the effect becomes the financial equivalent of shouting “fire” in a crowded room. I believe this quest for the cover of sameness, without gaining much attention or breaking any rules, is quietly killing our markets, our economy, and our spirit.

I seek to change the tenor of acceptable financial dialogue. In so doing, I hope to undo the creeping cowardice permeating our markets. No longer should it be acceptable to make an investment on behalf of others simply because that investment has worked in the past. No longer should a fiduciary be able to defend a choice because others were doing the same thing. From now on, the actions of investment professionals need to be held to greater scrutiny—the scrutiny of logic and personal judgment.

I hope to explain how the culture of doing what the other guy does has come about and how you can see it in action. The best help I can give you is to show you how to recognize this cowardly mind-set so that you can take the opposite side of the trade. I will also familiarize you with some of the financial assets, such as convertible bonds, that can help you do this.

I spent the better part of 20 years on Wall Street in a variety of roles. I’ve worked on mergers and helped companies sell stocks and bonds to the public. I’ve traded and researched options and convertible bonds for several top Wall Street firms and managed portfolios at a couple of hedge funds. I’ve been involved in managing funds at the top and bottom of the performance rankings, so I have a pretty good sense of the cycles of things. I’ve also taught and lectured about my experiences at a number of schools, including my alma mater, Yale.

The first hedge fund I worked for was a great success during the 2000–2002 period of glory for convertibles. We went from managing about $25 million in convertibles to over $1 billion during that period.

I felt like a minor-league rock star those days: Investors had to line up to get five to 10 minutes of my time. I liked to think it was because of my skills at explaining the nuances of convertibles, but the reality was we were performing well and people entrusted with other people’s money wanted to be associated with us.

I think I knew we had peaked when I was brought into a room to meet with a prospective investor one day in the fall of 2002. The marketing guy running the meeting told the client, loudly and forcefully, “These guys are number one in the rankings.” It was never our objective to be near the top of the list—most of the time it means you probably took too much risk and got short-term lucky. I tried to downplay the marketer’s comments—he was, as the expression goes, as subtle as a train wreck—but the damage was done. Our subsequent performance wasn’t awful, but we plummeted in the standings as our approach, which did best in a declining equity market, lagged as people started thinking the world might not come to an end. Once we had been labeled as stars, our performance was doomed.

When I was a college junior, I took a course in econometrics, the study of finding theories that fit data and using them to make predictions and evaluations. I had always been a big baseball fan and these were the early 1980s, when top players were starting to make seven-figure salaries. I updated a 10-year-old study, going to various libraries to dig up numbers on player salaries and team revenues.

It occurred to me that one shortcoming of the otherwise insightful study I was updating was that it focused entirely on player performances. In other words, it made no attempt to capture the fact that baseball is entertainment, and that fans will pay to see certain players not only for their performance but also for their reputation.

The two are linked, but not always as much as one might think. I found that you could explain a significant portion of a player’s salary, over and above what you could assign to his statistics, by whether or not he had made the All-Star Team the previous year. There seemed to be clear value that owners would pay for reputation that was not justified purely by the players’ individual output. It’s likely that in baseball—as well as in other professional sports—players are often past their prime when they reach their top compensation levels. Owners are effectively paying for players’ marquee status, for the statement the owners think they are making to fans that “we are trying to win,” as well as to satiate the owners’ often outsized egos.

And so it goes on Wall Street. The business is exhausting, and while the life expectancy of a portfolio manager is certainly longer than that of a professional athlete, it’s not a career most people can do indefinitely at a high level. More to the point, it’s often said that “size is the enemy of investment performance,” and it’s true. As a portfolio gets bigger, as a manager, you’re forced to start betting against yourself. Positions cost more to enter, are harder and more expensive to exit, and you have to find more good ones.

I experienced this firsthand in my first hedge fund manager job. Our excellent performance in the first couple of years led to big inflows even as the overall market size stayed roughly constant. We had to increase the sizes of our positions to accommodate the flows and look for new places to put money, in both cases beyond what we might have wanted to do in a perfect world.

Of course no world is perfect, and the best portfolio managers (a group in which I do not pretend to claim membership) can often find ways to navigate this curse of success. But the fact remains that, once a portfolio has grown significantly, its best performance days are likely behind it.

Since this is no secret, you might wonder why investors clamor to get into large funds and are so reluctant to invest with promising smaller managers. Think of them as the owners of baseball teams, going out and paying for athletes who have put up big numbers in the past but are now likely past their prime. Just as these owners get a certain personal satisfaction from reeling in a big fish, so an asset allocator feels he or she has become part of a club when investing with a famous manager. If the manager doesn’t perform to past standards, the allocator feels it was just bad luck and in any case not something for which he or she can be held culpable.

By the way, who are these asset allocators? I use the term loosely here. In general, I am talking about investment professionals whose primary role is to gather funds from individuals and institutions and then decide which other professionals, with their respective areas of expertise, should pick the securities and make the buying and selling decisions. But the general selection process they often use, a process I find wanting, also pertains to too many other investment professionals. We will learn more about these in our discussion of actual and “closet” index funds.

Let me be clear: Some of these asset allocators are outstanding, forward-thinking, creative professionals who focus not just on bottom-line performance but also the thought process and operational skill that ultimately generate results. The best allocators try to get ahead of trends instead of missing the wedding and arriving just in time for the funeral. It has been my privilege and pleasure to work with some of the best allocators around. But it has also been my great disappointment to see that far too many do not operate this way. Helping you understand the shortcomings of their suboptimal approaches—and helping you see how you might manage your own funds differently—is one of the focal points of this book.

As an individual investor, you want to attune yourself to what these allocators are chasing, and make sure you do not follow them.

It’s critical for you to understand the power of their contrary indicators. They are seeking the safety of being on the right side of contemporary public opinion, something that rarely leads to investment success.

There’s something else about All-Star ballplayers and Wall Street. Only a few players are good enough for fans to choose them for the All-Star team. But a lot of players make the major league rosters and hang on tenuously, often being shipped down to the minor leagues as their teams’ needs dictate and replaced by minor leaguers who shuttle back and forth. It’s safe to say that few, if any, fans are paying specifically to see these marginal major leaguers. Yet their performance on any given night can have a huge impact on what happens to a team.

You’ll see a “ratcheting” effect on the salaries of borderline major leaguers. While they get paid a fraction of what top players make, they also get paid many times the salaries of the average minor leaguer, even though their performance and ability are often indistinguishable from a minor leaguer’s. One could argue that—even though not many players are even good enough to get to this point—these marginal players are actually far more overpaid than the indisputable stars that make significantly more absolute dollars.

Similarly, Wall Street has a very small number of genuinely talented performers. Most people employed in the business are reasonably competent, but not inordinately so. I won’t make any friends for saying this, but most of the people I have met who make six- and seven-figure incomes are no more talented or capable than people in other fields working for a fraction of the pay. Small wonder, then, that there is pressure for those who have made it to these jobs to perform “in line” and hold on to these arguably overpaid roles. They don’t want to get demoted to the minors, so they don’t want to make themselves obvious candidates by making costly errors. A ballplayer who tries to make the difficult plays will invariably be charged with more errors than the players who attempt only to field the balls hit directly to them—but who is more valuable to the team?

The point of all this is to get you to focus on what you are really paying for when you think you are buying professional investment management. Are you chasing after a manager who’s now probably running more money than he or she can profitably manage, putting you unwittingly in the role of an owner paying top salaries for fading superstars past their prime? Even more alarmingly, is your money going to support a team of overpaid minor-league talent more concerned with getting paid major-league money than playing the game to win?

I want you to learn how to read the papers and follow the news to understand what too many of these immobile players (read: “asset allocators”) are doing. They are trying to keep their jobs, trying not to look bad. But you don’t make money by not looking bad. When you start to recognize their fear and mediocrity, and start learning to do the opposite of what they are saying and doing, you will be on your way to success.

This book does not give you specific investment recommendations—although you will find the argument throughout that a portfolio of convertible bonds, well chosen and patiently held, will probably give you a better risk/reward trade-off than most of the investments you currently own. And I talk about how to identify and buy those bonds. But the real idea with this book is to give you the tools and processes to get you comfortable thinking for yourself.

It’s the best investment approach you’ll ever have.