The Globe and Mail, Report on Business
Published January 5, 2008

Over the holidays I had a chance to read Michael Mauboussin's More Than You Know: Finding Financial Wisdom in Unconventional Places. From his perch as chief investment strategist at Legg Mason Capital Management (home of Bill Miller), Mr. Mauboussin has written an insightful book on investing and investment management.

Throughout the book he addresses the "tension - and perhaps growing imbalance - between the investment profession and the investment business." He defines the profession as "managing portfolios to maximize long-term returns" and the business as "generating (often short-term) earnings as an investment firm."

At the core of the profession-versus-business tension is the notion of time frame. In an ideal world, portfolio managers make investment decisions based on a multiyear view; they can buy underpriced securities knowing that it may take a few years for the value to be reflected in the market. The more freedom managers have to push out their time frame, and take advantage of the myopic nature of the markets, the better chance they have of creating wealth for their clients.

But with that freedom comes a downside. A truly long-term portfolio is more likely to be out of sync with the market for a considerable period of time. Of course, out of sync "first quartile" is great. Out of sync fourth quartile, however, takes the sales team out of the game and puts the business plan at risk.

An asset management firm also has to find a balance on how far out of sync it is willing to be compared to the competition and the industry benchmark - for example, the S&P/TSX Composite Index. In the short run, clients won't fire a manager for lagging the index by a few percentage points, but they might if the portfolio is 10- to 15-per-cent behind.

The starkest example of this dilemma I've ever seen occurred in the late 1990s when Nortel was in its glory. The stock was going up so fast and was such a big part of the market - it accounted for over 30 per cent of the S&P/TSX at one point - it was defining firms' short-, medium- and long-term performance records. Managers who didn't own Nortel watched as their hard-earned record rapidly deteriorated. It was a time when investment decisions were being made for business reasons: "We have to own this thing or we'll lose clients."

In the end, the firms that stuck to their investment disciplines and absorbed the criticism made the most money, but that wasn't revealed until much later, and, in many cases, redemption came after clients had already left the fold.

The profession-versus-business tug of war also affects the types of securities portfolio managers can own. It is all right to go wrong with a company that is well financed and highly regarded. Clients aren't too critical of that. If a controversial name hurts performance, however, the manager is likely to hear about it. And the comments are hard to respond to: "I thought you were more prudent than that. What were you thinking when you bought that company? It's obvious there was no value there."

My former partners at Phillips Hager & North and I faced this situation in 2002 when we held a position in Rogers Communications. The company was overleveraged and had a poor reputation for service (remember the controversy around negative option billing?). Canadians loved to hate Rogers. In that context, our portfolio manager was convinced (rightly) that the cable and wireless assets were severely undervalued, but the stock had been pummelled. I remember more than a few client meetings when I took grief for holding Rogers. We stuck with it, however, and in the end ultimately made them money.

Finally, one of the most difficult tradeoffs relates to how big a firm is allowed to get. Generally speaking, scale is good for profits, but bad for client returns. It is widely accepted that the larger the asset base, the more difficult it is to produce superior results. As firms get bigger and busier, there are less securities for them to invest in, and the founders and key money makers get further removed from the decision-making process.

But it's tough to turn down new clients. As sure as rain in Vancouver, there comes a time in a firm's performance cycle when nobody is knocking at the door and existing clients are looking elsewhere. Knowing that, it is a far-sighted and gutsy management team that will close for new business to protect the returns of its existing clients.

In the end, all of us in the industry have to ask ourselves where we are on the spectrum between asset manager and asset gatherer. How do we balance the needs of our portfolio managers - time, freedom to be different and a right-sized asset base - with the conflicting needs of our business managers?

For me, Charley Ellis, a renowned thinker on investment management, sums it up best when he says, "The optimal balance between the investment profession and the investment business needs always to favour the profession."