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Monday, November 29, 2010
Many years ago, in a different universe, I had a streak of luck with a small fund. As I recall, it was a few million. It was a Treasury bond fund. I saw myself as a superb market timer; and when I took over the fund, I judged yields as being excessively high. I invested aggressively in 20-year and 30-year Treasuries. Treasury yields at the time were double digit.
As soon as the the investments were made, yields dropped like a rock. The push up in bond prices yielded a nice capital gain and, to capture my good luck, I realized the capital gain and put the proceeds in 1- and 2-year maturities. As soon as these buys settled, yields shot back up and I re-entered the market. This went on a few times during the quarter, and after a while I was feeling like King Midas.
When the quarter ended and the smoke cleared, I found my fund was the third best-performing fund in the country. Pensions & Investment Age produced the rankings and, in their quarterly performance issue, interviewed me along with other "top" managers/bond market rock stars.
I gave my burgeoning rock star status considerable thought, and it dawned on me that I could lock in this superior performance for a long time by "closet indexing." In the bond market, this would mean structuring the bond portfolio similar to the Aggregate Index - its benchmark. The portfolio would have the same average coupon, duration etc.
All of this is more complicated to explain than to carry out. By "closet indexing" I would retain the superior performance for some time while not taking a risky market timing posture. The superior performance would attract money, thereby increasing the size of the fund. Bringing money in, of course, is the purpose of institutional money management.
The reason I relate this story is twofold. First, you need to be careful in evaluating performance. A fund's performance may look good but really be the result of one period's luck. By coming into the fund and paying high fees to attain superior performance, you may be buying into a conservative approach - one which could be attained at much lower costs. Or worse, the manager comes to believe he or she is King Midas and it takes time to realize that the prior results were luck. Secondly, it is easier to produce exceptional results with a smaller fund. The history of Wall Street has many instances of funds which started out on fire and gradually turned mediocre as asset size grew.
As it turned out, I was recruited to go to another investment management company that offered me more opportunities. Still I wondered over the years how much money would have come in with the "closet indexing" approach for that fund.