Sunday, May 10, 2015

Great Music Can Discipline Good Investing


The global equity surge on Friday was a political relief rally for stock owners.  The rise could restore the rhythm of alternating up and down months, with May being scheduled as an up month.  This cycle could be considered a possible link from the musical world to the investment arena.  Patterns or streaks in the investment world break down eventually, however great classical music goes on forever.  

Recently I was in Europe on a group tour with donors to the New Jersey Symphony  Orchestra (NJSO), and my wife Ruth, who is the orchestra’s Co-Chair. Before the official beginning of the tour we were in Geneva on family-related matters where I noticed a billboard for a concert of the local Orchestre de la Suisse Romande, which is the orchestra for the French speaking portion  of Switzerland. The orchestra’s visiting conductor for the night was Neeme Järvi, formerly the Music Director for the NJSO. We attended the concert and listened to familiar pieces by Franz Schubert and Ludwig van Beethoven which we heard
Maestro Järvi conduct in Newark, New Jersey. When we visited him and a portion of his large, talented family backstage, he was the same genial host we had known.
While in Prague (or spelled locally, Praha) we heard the Parnas Ensemble, a quintet playing highly spirited pieces by Mozart, J.S. Bach,
Dvořák, Bizet, and Brahms. What does this have to do with designing the correct components to an investment portfolio? Many of the pieces we heard were two hundred years old  and yet sounded new and exciting to us, even though we had heard them performed by individual soloists, quartets, quintets, chamber music groups or full symphony orchestras around the world. At each concert highly trained musicians interpreted the pieces in a different way so it was like hearing the music for the first time.

Turning to investment portfolios

Just as the musicians mix various instruments into their pieces, my structure of timespan portfolios can include real estate, commodities, fixed income securities, stocks from around the world, and my specialty mutual funds. A well-thought investment portfolio can be imaginative and fresh to a savvy investor similar to the experience one receives when leaving a concert that has produced evocative interpretations from old musical works. Similarly, a well chosen set of timespan portfolios can fill a deep and newly awakened investment need.   

Inter-relations between timespan portfolios

The structure of the first four portfolios is dependent on each of the Operational, Replenishment, Endowment, and Legacy Portfolios doing its job and relying on subsequent units to do their job. One of our perceptive readers, a professional portfolio manager, and one of my sons, asked the question, “How much of one's wealth should be devoted to each stage?” Unfortunately, there is no set answer.

The continual process of development

One begins sizing the initial timespan portfolio, the Operational Portfolio, with the first version of a funding needs spreadsheet starting with a two year spending budget estimate (including a reasonable contingency factor). Input by the CFO and/or external accountant is critical as well as the real planning officer, often the CEO.

The task of assessing the size of the second portfolio, the Replenishment Portfolio, is to make a somewhat independent judgment of the probability of the timing of the exhaustion of the Operational Portfolio, which is slightly dependent on the expected interest rate and cash flow in that account. This timing will determine the probable schedule of replenishment.

There is no hard math as to the allocation of capital to each of the four separate portfolios. Assuming that spending can be limited to 3% of capital, the Operational Portfolio should get two years of spending or 6% of the total. In the current time period, I am assuming no real income generated over minor administrative expenses will be paid out.

The Replenishment portfolio normally should have a five year timespan during which one should expect at least one period with a 10-20% decline. Making the bold assumption that on average, equity markets continue to rise about 9% per year, it is reasonable to assume that in aggregate, including any decline, they could produce replenishment capital of about 6% of the portfolio value. On the basis of this logic and on assumptions given, the Replenishment Portfolio should represent 50% of the capital of the account, assuming no additional contributions. (If in cash, additional contributions could substitute for some of the estimated rates of return.)

The Endowment Portfolio

Utilizing the above general example, there remains 44% (100% minus 6% minus 50% =44%) to be split between the Endowment and the Legacy Portfolios. How the split is made may be a factor as to how the current generation of senior management perceives the identified long-term needs of the account organization. If the organization has been regularly investing for its future, or if the family grantor perceives that the existing family members will receive enough without ruining their incentives to be productive, the bulk of the 44% might go into the Legacy Portfolio for expected but unknown needs/opportunities.

Even when heavily invested in equities, an endowment account is typically going to be judged on its long-term generation of income, including realized gains. A Legacy Portfolio should be judged on its ability to grow its capital.

Music lessons for investors

There are many ways to hear a great piece of music, but hearing the different approaches gives the listener a broader array of benefits and can lead to different choices for different listening pleasures. The same thing can be said at analyzing different portfolios with some of the same positions. A number of so-called active portfolios might hold shares of Apple, Google and IBM. For sake of discussion, assume that each holding represents 5% of the total portfolio and in aggregate 15%. (I know of no such fund portfolio.) One might expect that portfolios with similar holdings would produce roughly similar results. This is rarely the case, for the other 85% of the portfolio is likely to produce meaningfully different results.

There are many answers as to why funds perform differently. When I was consulting with the independent directors of fund groups trying to judge whether they should renew investment management contracts, I pointed out important differences beyond performance and holdings. I will admit relatively few directors wanted to listen to the whole piece. Some of the elements I mentioned to them were as follows:

1. How well did the managers follow instructions in the prospectus
    and from the board?
2. The impact of differences in fees and expenses.
3. Different flow characteristics.
4. Management of critical personnel + backup development.

Let me over-simplify a comparison of Warren Buffett/Charlie Munger of Berkshire Hathaway and Peter Lynch, the great long-term portfolio manager of Fidelity's Magellan Fund, who had similar performance in some years and from time to time actually owned a portion of the same stocks. Both Buffett/Munger and Lynch had professional disdain toward economic projections, but they each played to different tunes. Buffett relatively through securities he owned, his large positions made him technically an insider with holdings of 10%+ of the voting securities. Because he had the use of the long-term float of other people's capital, he was leveraged. Peter was very conscious that his good investment  performance was bringing to Magellan bundles of capital, with Magellan becoming the first equity fund to have assets of over $100 billion. Peter was very conscious that as easy as the money came in it could go out, as learned by the managers who followed him. The portfolio swelled at one point to perhaps 1800 individual issues, including 130 with the initial name "First" (as in Savings & Loans and Savings Banks). At one point he had three traders working effectively just for Magellan’s accounts.

In assessing investors' risks with these managers, Buffett represents a leveraged, highly concentrated balanced portfolio which he personally owns as a 50% principal in the company. To an extent his favored investment period was and is forever. Magellan was going to be only as good as its short-term performance with a broad equity portfolio.

While these three great minds made great investment music which seemed similar; just as one hears the difference between great orchestras playing from the same score, the results were quite different. A careful analyst of portfolios needs to understand the differences between outcomes and casual features.
Question of the week: What are the differences that you think are important other than past/present outcomes?
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