.
Tanous: What do you think?
Sharpe: Yeah, | think that that is one of the anomalies which sug-gests that, if your costs are low and your trading efficiency is high,there are some things you can do to gain a little advantage.
Tanous:To people like us, one of your great contributions to theinvestment industry is the Sharpe ratio. Everybody in the businessuses it. [The Sharpe ratio is a widely used statistic which measuresrisk-adjusted portfolio performance. In other words, did the returnsjustify the risk taken? For an expanded discussion, see page 17.]
Sharpe: It’s funny how that lay fallow for so long, then all of asudden it’s come to the fore.
Tanous:It’s amazing. This is the one of the sexiest tools we consult-ants havel
Sharpe: Probably misused, of course!
Tanous:Maybe so. In fact, my question relates to that. It is interest-ing to me that a ratio named after you, a Nobel laureate and passiveinvestment proponent, is used by us to show an investment manager’srisk-adjusted contribution to return. That means, of course, that weuse this ratio to help select active managers. Where did we, or you,for that matter, go wrong?
Sharpe: If you want to take on active management and add activerisk in the hope of active returns, you ought to be thinking abouthow much active return you’re expecting to get per unit of active riskyou're expecting to add. That’s the measure, as you say. I’m agnosticas to how you form those expectations. If you’re a real believer inpassive management and efficient markets, you'll assume that theactive managers will add on average negative amounts per unit oftisk and then you won't give them any money at all! [Laughter]
Again, I’m interested in the normative aspects as well. I certainlywork with people who believe that their active managers have anexpected positive added value. The question is, how do we put thatinformation together and come up with an appropriate mix, not onlyof active and passive, but also how we allocate the active moneyamong them?
Tanous:But look at the contribution you’ve made to active manage-ment. The Sharpe Ratio is one of the most important tools we have
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to evaluate a manager’s risk-adjusted value based on his managementhistory. Those are the guys we want to hire.
Sharpe: The manager’s added risk in the past is a pretty good pre-dictor of added risk in the future. The added return in the past, becauseof a relatively small degree of persistence, is a pretty rotten indicatorunless it is big and negative. Most of the studies over time have said:Give me a manager with a positive alpha fa measure of excess return]and a manager with a negative alpha, and the probability is 50/50that they'll be above whatever the average alpha is next period,whether they’ve been positive in the past or negative in the past.
We're now beginning to find that it is not quite that stark. The kindof number that I have found over the years is something like this:Give me the manager who was the very best in terms of average returnalpha or Sharpe ratio, for that matter, in the last five years, the 100thpercentile manager. Then ask me to make my prediction as to whatpercentile he or she will be in over the next five years. I wouldn’t say50th, but I probably wouldn’t say more than 55th. And that’s to amajor extent because I have some assurance that the guys in thebottom are going to be more likely to be in the bottom in the future.Tm talking, of course, about the high expense ratio, high turnovermanagers.
Tanous:So, if we set out as an objective to consistently have themanagers we select as being, say, top third, are we kidding ourselves?
Sharpe: You bet. But let me be careful before I answer your ques-tion. You’re going to select, what, ten managers?
Tanous:Say.
Sharpe: Okay, ten managers. The question is what’s the probabilitythat all of them will be in the top third? Or that the weighted averagewill be in the top third?
Tanous:Say all of them.
Sharpe: I would say that the probability is, basically, zero.
Tanous:Over the next five years?
Sharpe: Yeah.
Tanous:How about 80%? Eight out of ten of the managers will bein the top third.
Sharpe: I would say, still, pretty small. The question you want toask is, assuming you give 10% of your money to each of these tenguys, will that portfolio of ten managers be in the top third?
Tanous:Thank you. What’s the answer?
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Sharpe: We have to decide what measure we’re going to use forthe ranking. If you mean value added, or value added per unit of risk,the Sharpe ratio.
Tanous:Let’s use the Sharpe Ratio.
Sharpe: My ten guys, compared to random combinations of tenother guys - because you’ve got some diversification benefits byhaving ten. So we’re going to, basically, take all the managers in theuniverse and make random combinations of ten of them. Now we’regoing to rank those combinations. Then we're going to take our guysand see where we are.
Tanous:That’s perfect.
Sharpe: Okay. And the question is, what’s the probability you'regoing to end up in the top third of the group?
Tanous:Exactly.
Sharpe: Well, unless you’re a whole lot better than most peopleare at doing this, I would say that the probability is certainly goingto be less than 50%.
Tanous:Statistically, the chance would be one out of three, right?
Sharpe: Well, yes. If you’re no better than anybody else. If you’rethe average consultant, it’s going to be one out of three. If you'rebelow average, the probability will be less than one out of three.
Tanous:A very sobering thought, Bill. Shall we move on to anothertopic? Let’s talk about your non-academic activities. Do you have aconsulting practice? I know you sit on a number of boards and youadvise people. Could you tell us a bit about all this?
Sharpe: I took some time off to set up a consulting firm, and didconsulting. | had a two year R&D phase and then four years of fulltime, full staff, and all the rest. Basically, what I wanted to do wasdeal with the problems of the pension sponsor. Asset allocation,manager performance, manager selection, liability, asset/liabilityanalysis and what have you. I knew there were big holes in the re-search on how you should analyze these things. One of my goals wasto develop techniques and databases to fill those holes, and make itall practical.
Tanous:Did you?
Sharpe: Yes, I think so. Style analysis came out of that and someother work, liability analysis and such. The first two years it was R&D.Then it was real consulting, where we had to deliver or they wouldn’tpay us! Now, what I’m doing is standard academic consulting with a
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few clients. Which is to say you call me and I'll definitely get backto you within a month! I don’t travel much. If they want to talk tome in person they have to come here most of the time. So it’s a dif-ferent level. I work with a small number of funds, mostly pensionfunds, and one private family with a lot of marketable investments.I work with Union Bank of Switzerland, as a strategic advisor on themoney management side. I’m over there a week every year.
Tanous: What do you talk about?
Sharpe: I talk about the study we did on the value stock effect inFrance, Germany, Switzerland, the U.K. and Japan. I’m not a researchdirector, although I kibbitz there to some extent. The rest of the thingsI do as a consultant are with [the Pension Fund] sponsor side. I workwith Calpers [the California Public Employees Retirement System] andAT&T, so I’ve got some fairly big clients, but I’m not the main-lineconsultant by any means. Episodically, I do style analysis of all theirmanagers, and risk/return trade-offs, and Sharpe ratios and that sortof thing. It’s analytic work. They do all the hard work. They have toget the data all ready. I just run it through various models. I also getinvolved in special studies. I don’t do them typically, but I kibbitz orcontribute or discuss with them how they ought to be done. It’s ahigher level consulting function. I’m not on- the-line consulting.
Tanous:I have this vision of a pension fund in which you are aconsultant and all the guys are waiting for you to leave the room beforethey dare ask about active managers!
Sharpe: You probably think that I’m much harsher on that than Iam. I’m skeptical, and I want to hold my clients’ feet to the fire. Iwant them to look very carefully at just what they’ve been gettingand look at it in a way that is as revealing as possible. I] have clientswho have very heavy passive stances and I have clients who have,basically, none. With the private family we are free to do anythingwe want - we don’t have a committee, we don’t have ERISA - this isall private money. I’m definitely bringing in some of my friends whodo active management.
Tanous: You actually have friends who do active management?
Sharpe: Sure. Barr Rosenberg, Lang Wheeler, Martingale, BostonInternational Advisors, Rob Arnott at First Quadrant. We’ve got somemoney we want to invest, so we look around the world for very, verysmart people who have a very well-developed story to tell. Therefore,we have reason to believe that whatever they’re doing might persist.
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Tanous:Imagine sitting where I’m sitting and speculating on whatit takes to get Bill Sharpe to recommend entrusting money to an activemanager.
Sharpe: First of all, | want a very well-defined product. I want aproduct to be defined relative to a benchmark. J want that benchmarkvery explicit. It can be a combination of standard benchmarks. Inmost cases it makes sense for it to be. But I want the manager to say,for example, we will manage relative to 60% this index and 40% thatindex. That’s the benchmark. And we will control the process so thatthe difference between us and that benchmark will remain withinbounds. And I want those bounds to be reasonably tight. The basicidea is, I want to know what it is they’re doing and the benchmark,or a combination thereof, is a good way to focus on that. I want toknow that they’re controlling the process, so we’re not taking wildbets. Then, J want to hear an awful lot about what the process is thatleads to the risk they do take.
Tanous:The methodology...?
Sharpe: Absolutely. Back tests are always wonderful, we knowthat. I want some history of success, but you only see the people whohave a history of success. You only see the products that have beensuccessful. I also want a very convincing story as to why they areable, or that they have some information that either others don’t have,or that they use information in ways that others don’t.
Tanous:Like a black box? [“Black box” is Wall Street jargon for acomputer program or formula that comes up with ways to beat themarket. There hasn’t been a completely successful one yet.]
Sharpe: No. It doesn’t have to be a black box. But it has to be astory, for example, we are looking at the following things that mostpeople don’t look at. Or, we’re looking at this - lots of people look atit, but we have done an analysis and know how to look at it in waysthat other people haven’t caught on to yet. You’ve got to have a verystrong story.
Tanous:Are there any intangibles like something about an individualyou can’t quite put your finger on?
Sharpe: Well, they have to be swift and really smart. Active man-agers are by and large pretty smart people. And these people havegot to be smarter than the average active manager, so that meansthey’ve got to be really smart. If somebody comes along and sayswhat we do is we buy high yield stocks...Well, I can buy high yield
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stocks myself. I] don’t need them for that. Now, maybe that’s a goodstrategy, but I’m not going to pay active fees for them to do it.
Tanous:! think it’s fascinating to hear someone as universally knownin the industry as you describe what it takes to pick active managers.
Sharpe: Well, it doesn’t mean that even if you do all that, you’regoing to add value! But that’s the way I do it.
Tanous:How have you done?
Sharpe: | don’t usually pick active managers myself. Remember,in my view, active management is something you do with your “madmoney.” For my client, I came in and kibbitzed the managers theypicked. J also try to slow them down from firing managers, since weknow that costs money. I tend to get involved more on the firing side.On the hiring side, I tend to focus on the style issues. In other words,if they say we’d like to hire X, then I look at X’s style and see if X isall growth stocks, then they’re up to their ears in growth stocks [i.e.,they are not style diversified].
Tanous: What is the practical application of this process?
Sharpe: Here’s an example: I’ve got a client who wants to put moremoney in active management. I’m trying to push a long/short strategy,which is my favorite active strategy.
Tanous:Please tell us about that.
Sharpe: In my best of all possible worlds, and if we get the costsin line, I would do all asset allocation with either index funds or fu-tures - because you know what you've done - and there’s no questionas to what you've got. Then, if somebody comes along and says, “I’mreally great at growth stocks. I can tell the good ones and the badones,” | might say fine, you’ve convinced me. I want you to go longthe ones you think are really good and short the ones you think areteally bad. That means that, net-net, you bring me no exposure togrowth stocks, or any other stocks. Basically, what you’re bringingto me is T-Bills plus, we hope, something in addition. That’s the onlykind of active manager I’d ever hire in the best of all worlds.
Now, the problem is that, except in U.S. equities and some of thefixed income classes, the cost of going short is fairly high. As a resultthat’s probably not the way to operate in all asset classes. I’ve giventalks about this which I sometimes call “a modest proposal to revolu-tionize the investment management industry.” It has another advant-age. If you did this, and you wanted the typical multiply-managedpension fund in terms of risk and returns, you’d only put about 20%
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of your total money with active managers. That’s because most activemanagers give you mostly passive retums plus a little bit of sizzlearound the edge. And you're paying active fees for the whole thing.
So, if I give a hundred dollars to some highly diversified activemanager, what I’m really doing is giving eighty or ninety dollars toan index fund with that style and the rest to a long/short strategyaround that index fund. If I give a manager ten dollars, he mightcharge me twice the fee that he used to charge, but not ten times thefee. That’s too blatant. That will also cut the cost of management fees,which is always helpful.
Tanous:I want to understand the long/short strategy in terms ofexpected returns and risk.
Sharpe: Basically you get the return on cash, plus selection returns.You add precisely the selection return and selection risk.
Tanous:But there are some extraordinary risks in being short any-thing.
Sharpe: Not if you’re long the other thing. You don’t get hammeredif growth stocks go down because you’ve got them on both sides. Inother words, the risk is the spread risk between your good growthstocks and your bad ones.
Tanous:! see. The idea is that in the same style, in this case growth,you take the ones you think are terrible and the ones you think aregood, and then go long the good ones and short the bad ones.
Sharpe: Most managers, whatever domain they look at, growthstocks or whatever, have a list, and at the top of the list are the onesthey think are really underpriced and great buys. Somewhere downat the bottom of the list are the ones they think are real dogs and arewildly overpriced. They don’t hold those bad ones, but they could getmore mileage out their information, if it is good, if they went shortthose bad ones and they’re stopped out at zero.
Tanous:Has this been back-tested?
Sharpe: Well, it’s been done, but it’s hard to back-test because youdon’t really know the cost of being short. But there are managers whohave done this and have strategies which have been long/short forseveral years.
Tanous:Have you seen this new scheme that has been published inseveral magazines, where you buy the ten highest yielding stocks ofthe thirty in the Dow Jones Average once a year. They've back-testedit and it shows great results. It’s called the Dow Dog theory.
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Sharpe: Let’s see, you buy the highest yielding, so it’s a valuestrategy. That’s consistent with the value stock results. Remember theold Bob Newhart routine? He reads a news article which says that ifyou put a thousand monkeys to work on a thousand typewriters fora thousand days one of them will type the Gettysburg Address, andNewhart is saying: “Let’s see, doctor, let’s see. Wait a minute...lookat this one: ‘Four score and seven...bananas...”” [lots of laughter]. Ifyou put enough monkeys to work with enough computers and enoughdata one of them is going to find some strategy that would have justmade you a fortune.
You can do that with random numbers, too. But on the other hand,the substance of your example could be the value stock effect andyou've read Lakonishok. I do not dismiss the behavioral aspects thatJoe [Lakonishok] and others have argued which is to say that thereare all kinds of reasons from cognitive psychology that suggest thata real dog is likely to get underpriced, and maybe people know it’sunderpriced and they still don’t want to hold it. It’s hard socially. Youthink about going to your clients and saying I want you to buy thisfund which holds the worst stocks in the world. We all like to holdstocks of great companies, what some people call admired stocks ofadmired companies. It’s a cognitive error that people make over andover again in experiments. They identify something - it’s called arepresentation error - and there are various experimental settings forthis, but it basically says “great company, great stock.” And if youthink about that, and survey investment people, CFOs and CEOs, theymake that assumption: it’s a great company, it’s a great stock. That’sthe growth stock story.
In an efficient market, you’d say: “great company, so-so stock.” Ifthe market is pricing stocks correctly, great company stocks are pricedto be just as attractive, but no more so, than bad company stocks.Thus, an efficient market. People generally say “great company, greatstock.” Efficient market people would say “great company, averagestock,” and to the extent that people are making the error of saying“great company, great stock,” it would follow that sometimes it wouldbe true then that “great company, rotten stock.” That is, it’s over-priced. That’s the value phenomenon.
Tanous:Earlier you described asset allocation in the best of allworlds. You mentioned using derivatives [futures], which I foundrather intriguing. Can you elaborate?
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Sharpe: I think derivatives, properly used, can be very helpful.[Any security which is dependent on another is, technically, a deriva-tive. That includes puts and calls, futures and other fairly straightfor-ward securities as well as the very complex securities which havegiven derivatives a scary reputation.] They can give you liquidity atlow cost. For whatever reason, | want to be able, if need be, to changefrom stocks to bonds. It’s a lot more efficient for me to hold a stockfuture and sell it and buy a bond future. At the same time you don’twant to switch from bonds to stocks so we'll just trade our futures,and nobody has to move all the securities around and do all the re-cordkeeping and whatever. So there is a role for these types of con-tracts that allow you to buy big diversified portfolios in a very liquidand very low cost manner. You can go beyond that and ask what if,for whatever reason, I want 80% of the upside of the market but wantto be assured that I won’t take more than, say, ten percent of adownturn.
Tanous:Sounds good to me.
Sharpe: Well, if that proportion is right, I'll sell it to you. Remember,you're giving up some of the upside.
Tanous:But if you’re talking about an upside/downside ratio of80% on the upside and only 10% on the downside, that sounds prettygood.
Sharpe: I’m not saying that we’ll floor you at a loss of ten percent.Basically, what happens is that if there’s any upside, I keep 20%, andif there is a downside below 90%, I'll make up the difference to you.There are numbers that make it profitable for me to sell this to you.For everybody who buys one of those deals, somebody has got to sellit. There is an argument that there are people who will want to buythat insurance and there are people who, for the right price, will bewilling to sell it. Derivatives are a very efficient way to do this. So,despite all the brouhaha about derivatives, you have to know whatthe derivative is, and you have to know how much leverage there is,and you have to know what is going to happen to you in variousplaces in the world, but once you get past that disclosure issue, thesecan be very valuable things. There is also the credit issue. You haveto know that the guy you’re doing it with is going to make good ifit goes against him. I do think these contracts are really very useful,but need to be used correctly with disclosure of the terms and thecreditworthiness of the counter-party. There are a lot of issues there.
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It’s all happened so fast that we haven’t quite gotten all the pieces inplace to make these as useful as they should be. But the futures mar-kets are fine. Futures markets are not a problem. They’ve been doingthat for a couple of hundred years and we know how to do it.
Tanous:!t’s just that they are so complicated that most people, ex-cept people who are selling them, can’t possibly understand them.
Sharpe: If you don’t understand what it is, don’t buy it! But that’sa burning issue and I think we are going to see a continuing movein this business toward separating the asset allocation decision andthe active management decision. Ultimately you'll end up using indexfunds, futures and derivatives for the asset allocation. Active managerswill be basically factor neutral, asset neutral, long/short, what haveyou. You don’t have to get all the way there. In many contexts it willcost too much in transaction costs to do it.
Tanous:At the end of the day, given all you are saying, are youlooking to get better than market returns?
Sharpe: The average dollar can never get better than market returns.
Tanous:Then why are you doing all this?
Sharpe: You're doing it (a) to make sure that you’ve got the assetallocation you want, and (b) to make sure you know just how muchmad money you've put with active managers and how big your betsare. It’s nice and clear. Here’s our asset allocation. We’ve got thismuch in this index fund, that much in that one, that much in S&Pfutures. We know exactly what our asset allocation is and we knowwe're going to get it. We’ve taken twenty percent of our money andput it in the bank as margin, as collateral, for these guys who aremaking bets out here, and we know exactly how much we’ve gotthere, and we have at least some reasonable notion of how big thebets are. It’s much better for your mental health than the situationyou might have with a bunch of active managers. You don’t reallyknow what your asset allocation is. You estimate it as best you can,but it’s not all that good. You’re not absolutely certain how big yourbets are. And there are other problems.
Tanous:What advice might you have for our readers who invest instocks?
Sharpe: Decide how much risk you are willing to take. Choose anasset allocation that makes sense, given the level of risk. Try to selectmanagers and funds that will give you that asset allocation. Keepyour costs low, and be realistic about the extent to which even a
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brilliant active manager can add value over a comparable passivestrategy. Nothing to it!
Investment advice from the winner of the Nobel Prize in economics!Remember, most of our academic community friends are proponentsof efficient markets. If they believe that the market can be beaten atall, they are equally certain that it is rare and hard to do. Now BillSharpe does like a few active managers. He gave some examples. |was particularly taken by his long/short strategy. It essentially takesthe market out of the picture and leaves you with rewards (if any)based on stock selection ability, which is the only thing you oughtto pay a manager for. We'll discuss this again in the concludingchapters of the book.
Note the emphasis on keeping costs low. This is consistent with thetheory that it is very difficult to beat the market, so every dollar youspend on fees, commissions, and other costs are dollars you have tomake up just to be even with the market. That increases the challengeand the difficulty. This is good advice no matter what you believe in.I came away from the conversation with Bill Sharpe somewhat awedover how someone as brilliant and accomplished as he could stillmanage to make his work - specifically his important contributionsto our knowledge of risk, style, and how the markets work - accessibleto most people interested in the markets. Nice going, Bill.
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What can I tell you about Peter Lynch? That if you had put $10,000in the Magellan Fund in 1977, the year he began to manage it, yourstake would have grown to $280,000 when he retired 13 years later?That’s close to 30% per year. That under his stewardship, MagellanFund was the top fund in America? That even after Magellan’s sizekept roaring ahead to become the largest fund of all time, Peter Lynch’sperformance did not falter? I could tell you all this, but you probablyalready know it. After all, we are talking about the most legendarymutual fund manager in history.
So, let’s talk about some things you may not know. In my consultingbusiness, consistency is one of the key traits we look for in pickingmanagers. Why? Because if I told you that a manager had a 30% re-turn over ten years, that would be great. But what if most of the per-formance came in the first two years when he had spectacular results,and the last eight years were mediocre? Well, if you happened to buythe fund in the last eight years, you were out of luck and your returnswould be considerably lower than the ten year average. But if a man-ager displays consistency in performance, you’ve got a much betterchance of making money with that fellow no matter when you signon.
Let’s reintroduce Peter Lynch. Not only are his numbers extraordi-nary, but there were virtually no bad times to hop on board. Of suchstuff legends are made.
If there is a single difficulty in interviewing Peter Lynch it is this:he is genuinely modest and unassuming. This is not an individualobsessed with himself or imbued with his self-importance. While thatmakes for one awfully nice human being, the trick is to scrape awaythe modesty to get at the underlying wisdom without making him feelthat he is thumping his own chest, something he clearly doesn’t likedoing. In this interview, I tried hard to break some new ground withPeter Lynch, by provoking ideas and thoughts not necessarily coveredin the three very successful books he’s written. I think we succeeded.There are pearls of wisdom here, and all of us can profit from theadvice of the master.
T interviewed Peter twice, the second time in Boston. Peter LynchPETER J. TANOUS
works in the picturesque setting of downtown Boston’s financial dis-trict, where winding, cobblestone streets evoke the early history of theUnited States. The stately Federal period building in which he main-tains his office proudly flies the green flag of Fidelity Investments. Inthe small lobby of the building, a discreet directory lists the nine floorsand their occupants. But one floor is not listed at all. That one, ofcourse, is his. Anonymity is the price of great celebrity.
At the entry to Peter’s office, the telltale signs of a security setupare visible, another legacy of fame. I am buzzed in and greeted byPeter’s assistant, Shirley Guptill. Peter comes out to say hello and afew minutes later, we are seated on opposite sides of his desk. Theoffice is small and functional; there are no trappings of great successhere. Papers are scattered around the desktop in no discernible order.It is high noon and I am offered a sandwich. Peter has brought hisfrom home in a little brown bag. Old habits die hard.
Tanous:How did you first get interested in stocks? I recall a storyabout you as a teenage caddie.
Lynch: I grew up in the ’50s. Except for the decade of the ’80s,which was slightly better, the ’50s were the best decade in this century[in the market]. The Dow Jones Industrial Average tripled over the’50s. I grew up in an environment when stocks were going up.Somebody would talk about a stock and you’d look it up later and itwould be higher. You’d look two years later and it was higher still.If somebody grew up in the ’30s, I guess they’d have a different out-look on life.
Tanous:So did you start investing right off the golf course?
Lynch: No. I didn’t have any money. My father took sick when Iwas seven. He died when I was ten. My mother went out to work. Ihad to help pay my way. There were scholarship jobs as caddies forstudents who needed financial aid. Tuition was only a thousand dollarsand I got a three hundred dollar a year scholarship. I could earn morethan seven hundred dollars a year in my part time jobs, so I had alittle bit of extra money. So, when I was in college, | bought my firststock.
Tanous:Do you remember what stock it was?
Lynch: Yes. Flying Tiger. How could I not remember that one!
Tanous:How did you do?
Lynch: It’s funny. I bought on the premise that air freight was goingto be a big market. It’s funny how things work out - something else
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happens and you get lucky. What actually made the stock a huge hitwas that the Vietnam War came along. Not only did that change theair cargo market, but they used every plane they could find in theworld to transport troops. It was a unique war. Everybody who wentto Vietnam went there by airplane. They didn’t go there by boat. Thecompany wound up with an unbelievable amount of business, so thestock went up for a different reason than the one I bought it for. Itwent up from about 1