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Memo to:

Oaktree Clients

From:

Howard Marks

Re:

What’s Your Game Plan?

As the summer ends, my thoughts turn to the tennis game I’ve been hoping to improve, the baseball season that’s moving toward a conclusion, and the football season that’s just getting started. It’s enough to remind me of the role sports play in our lives . . . and in our thoughts about investing.

How Oaktree Plays the Game

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Sometimes I feel I should apologize for the frequency with which I use sports metaphors to express my views on investing. And I worry that they’ll fall flat in Europe and Asia. But that doesn’t seem to stop me. “The key to investment success isn’t hitting home runs; it’s avoiding strikeouts and inning-ending double plays.” I say this over and over . . . and over . . . as you’ve no doubt experienced. But I truly believe it. Investing is a testosterone-laden world where too many people think about how good they are and how much they’ll make if they swing for the fences and connect. Ask some I-know-school investors to tell you what makes them good, and you’ll hear a lot about home runs they’ve hit in the past and the home runs-in-the-making that reside in their current portfolio. How many talk about consistency, or the fact that their worst year wasn’t too bad? One of the most striking things I’ve noted over the last 35 years is how brief most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically non-destructive vocation. Where are the leading competitors from the days when I first managed high yield bonds 25 or 20 years ago? Almost none of them are around anymore. And astoundingly, not one of our prominent distressed debt competitors from the early days 15 or even 10 years ago remains a leader today. Where’d they go? Many disappeared because organizational flaws rendered their game plans unsustainable. And the rest are gone because they swung for the fences but struck out instead. That brings up something that I consider a great paradox: I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the

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game because they strike out too often – not because they don’t have enough winners, but because they have too many losers. And yet, lots of managers keep swinging for the fences.   

They bet too much when they think they have a winning idea or a correct view of the future, concentrating their portfolios rather than diversifying. They incur excessive transaction costs by changing their holdings too often or attempting to time the market. And they position their portfolios for favorable scenarios and hoped-for outcomes, rather than ensuring that they’ll be able to survive the inevitable miscalculation or stroke of bad luck.

At Oaktree, on the other hand, we believe firmly that “if we avoid the losers, the winners will take care of themselves.” That’s been our motto since the beginning, and it always will be. We go for batting average, not home runs. We know others will get the headlines for their big victories and spectacular seasons. But we expect to be around at the finish because of consistent good performance that produces satisfied clients.

For Me, It Started With Tennis

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In July, Larry Keele and I met with the Directors of the Vanguard Convertible Securities Fund to report on Oaktree’s performance as the fund’s manager. I was extremely pleased to see Charles Ellis of Greenwich Associates, one of the great thinkers in the investment field, whom I hadn’t come across in many years. I was especially pleased to have a chance to tell him about the seminal part his 1975 article, “The Loser’s Game,” had played in the development of my thinking. The article employed a metaphor that was simple but profound. Charley’s article described the perceptive analysis of tennis contained in “Extraordinary Tennis for the Ordinary Tennis Player” by Dr. Simon Ramo, the “R” in TRW. Ramo pointed out that professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that his opponent can’t return. But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss-avoidance strategy the version of tennis I try to play. Charley took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners is unlikely to pay off. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling. I can’t remember saying, “Eureka; that’s the approach for me,” but the developments over the last three decades certainly suggest his article was an important source of my inspiration.

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Because of his conviction that markets are efficient, Charley recommended passive investing as the best way to end up the winner – let others try the tough shots and fail. Oaktree’s view is a little different. Although we believe in the existence of inefficient markets as well as efficient ones, we still view the avoidance of losers as a wonderful foundation for investment success. Thus we diversify our portfolios, limit the fundamental risk we’ll take, try to buy things that provide downside protection, and emphasize senior securities. We, too, try to win by not losing.

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Which Team Do You Want Out There?

I recently came up with a new sports metaphor that handily illustrates a crucial choice each investor has to make. It goes like this: Think about a football game. The offense has the ball. They have four tries to make ten yards. If they don’t, the referee blows the whistle. Off the field goes the offense and on comes the defense, whose job it is to stop the other team from advancing the ball. Is football a good metaphor for your view of investing? Well I’ll tell you, it isn’t for mine. In investing there’s no one there to blow the whistle; you rarely know when to switch from offense to defense; and there aren’t any time-outs during which to do it. No, I think investing is more like the “football” that’s played outside the U.S. – soccer. In soccer, the same eleven players are on the field for essentially the whole game. There isn’t an offensive squad and a defensive squad. The same people have to play both ways . . . have to be able to deal with all eventualities. Collectively, those eleven players must have the potential to score goals and stop the opposition from scoring more. A soccer coach has to decide whether to field a team that emphasizes offense (in order to score a lot of goals and somehow hold the other team to fewer) or defense (hoping to shut out the other team and find the net once), or one that’s balanced. Because the coach knows he won’t have many opportunities to switch between offensive and defensive personnel during the game, he has to come up with a winning lineup and stick with it. That’s my view of investing. Few people (if any) have the ability to switch tactics to match market conditions on a timely basis. So investors should commit to an approach – hopefully one that will serve them through a variety of scenarios. They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers. They can emphasize defense, hoping to keep up in good times and excel in bad times. Or they can attempt to balance offense and defense, giving up on tactical timing but aiming to win through superior security selection in both up and down markets. Oaktree’s preference for defense is clear. In good times, we feel it’s okay if we just keep up with the indices (and in the best of times we may even lag a bit). But even average investors make a lot of money in good times, and I doubt many managers get fired for

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being average in up markets. Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above average results over full cycles with below average volatility, and our clients will enjoy outperformance when others are suffering. We think that’s a winning long-term combination. Our game plan is built around defense. But that’s not enough. We still need players with superior skills.

Finding Your Role Model

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An article in the Wall Street Journal of August 8, entitled “Greatness in Our Midst,” supplied the immediate impetus for this memo. It attempted to determine “who’s the greatest living baseball player?” I’m no expert on baseball, but I liked the Journal’s analytical approach and loved its conclusions. Of the five players discussed, Barry Bonds came in fifth. “If you’re looking for a peakvalue player – a guy to play one season as well as anyone ever has – this is your guy. His past two campaigns have been other-worldly . . .” Bonds has a ton of ability, but he has yet to prove that he’s “the greatest.” Lots of fence-swinging investors have had otherworldly years, but few have completed outstanding careers. Stan Musial placed fourth: outstanding at the plate, but below average on defense according to the Journal. It’s tough to be the best without strong defense. The #3 pick was Willie Mays. He ended his career with excellent stats in many offensive categories and he was an outstanding fielder, having made what has to be the most famous catch in baseball history. Surprisingly, however, “in a career full of milestones, such as 3,000 hits and 600 homers, Mr. Mays doesn’t own a single significant major-league record.” Records aren’t what it’s about; I think its competence, consistency, and an absence of weaknesses. I like the way Ricky Henderson made it to runner-up. “Walks aren’t sexy and steals aren’t trendy,” but Henderson holds the career record in both, and they positioned him to score. “And no one’s done this more often than Mr. Henderson.” It’s kind of like being a steady performer in an unfashionable niche like convertibles, underdeveloped real estate or power infrastructure. The Journal’s pick for greatest living player: Henry Aaron. Unlike Willie Mays, the Journal says, “Hammerin’ Hank holds more important records than any player in history: home runs, runs batted in, total bases, extra-base hits and Aggregate Bases,” (which it defines as the sum of hits, extra bases, walks and steals). And I love the way he did it: “Mr. Aaron’s best seasons don’t compare with those of Messrs. Bonds, Mays or Musial, but he played at a high level longer than any player in the history of the game.” In my book, that’s the definition of #1.

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Few people, in any field, can hope to have talents and abilities like these men. But each of us can try to apply the same work ethic, and we can select our role models and decide how to conduct ourselves professionally. I want an Oaktree that’s like Willie and Hank. An exceptional career, even if it doesn’t result in entries in the record books. Or a number of records, but for a lifetime, not a single great year. “Steady Eddie” Murray was inducted into the Baseball Hall of Fame just six weeks ago. He drove in at least 75 runs a year for a major league-record 20 consecutive seasons. I’d like Oaktree’s play to be described as “Steady Eddie.” Sandy Koufax was pretty steady, too. In the six years 1961-66, he was named an All-Star six times and led the league in earned run average five times, in strikeouts per inning five times, in hits allowed per inning five times, in hits and walks allowed per inning four times, in shutouts three times, in innings pitched twice, in won-lost percentage twice, and in complete games twice. He pitched a no-hit game every year from 1962 to 1965, and the last of those was a perfect game. Over that period, he essentially had no weaknesses. And, of course, I can’t fail to mention Cal Ripken, Jr. He played all of his 21 seasons with the Orioles, a great oddity in a time when there’s little constancy. And speaking of constancy, Cal is well known for his record of playing in 2,632 consecutive games, spanning a 15-year period. He also played 8,243 innings without missing one. Always there for his teammates and fans, he was chosen to start at shortstop in 17 consecutive All-Star games. These are my baseball heroes. They personify my aspirations for Oaktree.

Playing Within Yourself

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An expression from the broadcasting booth that’s relevant to investing relates to the need to avoid pushing too hard. “Playing within yourself,” they call it. It means not trying to do things you’re not capable of, or things that can’t be accomplished within the environment as it exists. When the defenders drop back to cover the deep receivers, the intelligent quarterback throws short passes until they move up. That opens up the downfield routes, enabling him to complete the long bomb. “He’s taking what they give him,” the commentators say, approvingly. It’s what we all must remember to do. We simply cannot create investment opportunities when they’re not there. In its first year, our newest distressed debt fund produced a 64% net IRR that’s eye-popping . . . and impossible to replicate any time soon. So what should we do now? Rather than take profits and distribute the proceeds, should we prolong our holding periods or try to repeat our gains in new positions? And would it be smart to raise a big new fund? None of these, if the prospective returns on our holdings are inadequate and new investment

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opportunities are limited. The dumbest thing we could do is to insist on perpetuating our high returns – and give back our profits in the process. If it’s not there, hoping won’t make it so. All we ever can do is take what they give us.

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What’s Better, Investing or Sports?

When people ask me what I like so much about investing, I usually go to the well for more comparisons to sports.     

It’s competitive – some succeed and some fail, and the distinction is clear. It’s quantitative – you can see the results in black and white. It’s a meritocracy – in the long term, the better returns go to the superior investors. It’s team-oriented – an effective group can accomplish more than one person. It’s satisfying and enjoyable – but much more so when you win.

Many of the things that make sports fun to watch and participate in are the same things that make investing a great area in which to work. However, Warren Buffett came up with one way in which the investor has it better than the athlete. In Berkshire Hathaway’s 1997 Annual Report, Buffett talked about Ted Williams – the “Splendid Splinter” – one of the greatest hitters in history. A factor that contributed to his success was his intensive study of his own game. By breaking down the strike zone into 77 baseball-sized “cells” and charting his results at the plate, he learned that his batting average was much better when he only went after pitches in his “sweet spot.” Of course, even with that knowledge, he couldn’t wait all day for the perfect pitch; if he let three strikes go by without swinging, he’d be called out. Way back in the November 1, 1974, issue of Forbes, Buffett pointed out that investors have an advantage in that regard, if they’ll just take advantage of it. Because they can’t strike out looking, investors needn’t feel pressured to act. They can pass up lots of opportunities until they see one that’s terrific. Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it. Buffett’s approach, like that of Williams, rewards patience, selectivity and a superior understanding of the underlying process. These are some of the things Oaktree likes to emphasize.

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Back to Tennis for the Wrap-up

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Just as this memo was going into the home stretch, the Wall Street Journal’s Allan Barra greeted the start of the U.S. Open tennis tournament with an article about Pete Sampras. For me, it provided the ultimate investment/sports metaphor. Mr. Sampras will need no future historians to make his case as the greatest tennis player of our time. His career credentials – the 14 Grand Slam singles championships; the 63-7 record in Wimbledon and seven Wimbledon titles in eight years; the 71-9 record at the U.S. Open with 87 consecutive service games won there; the six straight seasons of being ranked No. 1 – do that admirably. . . . Sampras the player wasn’t always exciting. Mr. Sampras’s outstanding quality was always his uncanny consistency. Was there an athlete of the past 10 to 12 years whose greatness has been harder to capture in highlights? His highlights were hard to distinguish from his lowlights. As I wrote in the Wall Street Journal a few years ago: “The definitive book on the man would have to be titled ‘Pete Sampras: The Dullness of Excellence.’ But who would buy it?” (August 26, 2003; emphasis added) The sentence I’ve bolded struck me as particularly thought provoking. You could read it as saying “his best moments weren’t much better than his worst moments” – not a very stirring thought. Alternatively, you could read it as “his worst moments were almost as good as his best.” In my view, that would describe a terrific money management career. We hope people will say it about Oaktree. *

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I’m always careful to point out that there are many game plans capable of leading to success. Offense or defense. Home runs or batting average. Go for the long bomb, or pick them apart with short passes. Battle from the baseline or rush the net. There are as many choices as there are sports metaphors. But the best game plan will only take you as far as the starting line or the first pitch. Once the game is underway, it comes down to skillful execution. The best strategy in the world won’t pay off without skillful blocking and tackling. And having a talented, disciplined team that stays together – a rarity in sports or investing – doesn’t hurt.

September 5, 2003

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Memo To:

Oaktree Clients

From:

Howard Marks

Re:

The Feeling's Mutual

Throughout the recent, seemingly endless series of scandals, complaints, settlements, indictments and meltdowns involving corporations, auditors, brokerage firms, investment banks and hedge funds, the mutual fund industry remained untouched. That held true until September 3, when the Attorney General of New York State announced that Edward Stern of hedge fund Canary Capital Partners had paid $40 million to settle charges relating to improper dealings between Canary and a number of mutual funds. Since then, sordid disclosures involving mutual funds seem to be emerging on a regular basis.

The Canary That Swallowed the Cat

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What did Canary do wrong? It admitted to "mutual fund timing" and "late trading." Both of these tactics take advantage of what I would call "temporal disconnects" in the process through which the price for transactions in mutual fund shares is set. A fund's Net Asset Value is supposed to reflect the per-share value of the assets held in the fund's portfolio, so that people buying or selling fund shares at that NAV pay or receive a fair price for their portion of the fund's portfolio. However, the process is non-dynamic, in that the NAV is set just once a day based on the underlying securities' latest closing prices and isn't updated for events that occur subsequent to the market closings or subsequent to the time of the calculation. Canary acted to profit from instances when security prices used to calculate the NAV had become "stale." Most forms of market timing consist of people undertaking trades in order to implement their views regarding the future direction of security prices. Mutual fund timing is different, however, because the fund timer acts to profit from events that occurred in the past. The opportunity for mutual fund timing arises from the fact that every fund's Net Asset Value is calculated as of the close of trading at 4:00 p.m. Eastern Time, and orders for fund shares entered up to that time are executed at that price. (Under the rules, orders placed after 4:00 p.m. are executed at the next day's NAV.) In brief, the mutual fund timer acts to take advantage of knowledge that a security price factored into a fund's NAV is out-of-date and not reflective of recent events. For an example, think of a mutual fund that holds a U.K. stock, the trading of which ceased at 4:30 p.m. London time. Since 4:30 p.m. London time is equivalent to 11:30 a.m. in New York, it's the stock's price at 11:30 a.m. Eastern Time that'll be used to calculate the NAV at 4:00 p.m. Thus a timer has 4½ hours in which to watch for a development rendering the London closing price obsolete, be it a general market movement or a company-specific event. In extreme

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cases involving infrequently traded securities, a timer may gain an advantage from knowledge that security prices haven't been updated for days or weeks. At first glance, this all appears relatively benign. It is not improper in itself to trade on knowledge that the prices of some fund holdings are stale. All investors have potentially equal access to this information, and they all have the same ability to enter orders for fund shares up to 4:00 p.m. Eastern Time. Further, most of these situations involve small pricing imperfections that relate to a small portion of the fund's portfolio, and trading on them isn't likely to materially change the return on a long-term investment in the fund. However, these trades can be highly profitable if the impact is magnified through minimization of the holding period. (E.g., taking advantage of a 1¢ error in a $10 NAV will add just .1% to the annual return if the fund shares are held for a year, but taking advantage of a new 1¢ disparity every day will increase the annual return by 25%!) Obviously, then, the key to achieving unusual profits through mutual fund timing lies in rapid-fire trading. The problem is that "knowledge-advantaged short-term trading" is inimical to the interests of a fund's other holders – in essence, these tactics permit a bystander to occasionally dart into the game and appropriate for himself some profit that otherwise would accrue to the fund's long-term investors (and also to run up the fund's costs). There are tools the funds can use to discourage short-term trading: they can impose exit fees, turn away investors based on their past behavior, or revoke trades. Many funds have policies of fighting short-term traders, and those policies and the actions the funds will take are set forth in their prospectuses. That's where the problem comes in. The complaint against Canary Capital states that, "Canary entered into agreements with dozens of mutual fund families allowing it to time many different mutual funds." Some of these funds ignored or contravened the policies stated in their prospectuses, and some accepted compensation for doing so. It is these actions on the part of the funds – and what Canary did to induce them – that are improper. Late trading is highly analogous to fund timing – it's another form of "knowledgeadvantaged short-term trading." However, in this form it consists of placing a buy or sell order for a mutual fund after the 4:00 p.m. deadline, for execution at the previously set NAV, in contravention of the SEC's "forward pricing rule." This is done in order to profit from developments that have occurred since 4:00 p.m. and thus are not reflected in the security prices underlying the NAV set at that time. Consider the example of a mutual fund that has 4% of its portfolio in a stock that closed today at $40. An hour after the close, the company announces startlingly good earnings. A "late trader" may conclude that the stock will trade tomorrow at $50, and thus that, everything else being equal, tomorrow's NAV will be higher by 1% (the 25% stock price increase multiplied by the 4% position in the stock). Thus at 5:30 he enters an order to buy the fund at today's NAV, implicitly buying the company's shares at $40 and trusting

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that the NAV will rise tomorrow. On average, these trades can be highly profitable . . . if the holding period is short enough. Late trading is less ambiguous than fund timing. It's wrong (and illegal), and no one should be able to do it. It, too, takes away some of the profit that should have gone to the fund's long-term holders. Again, Canary made improper arrangements that allowed it to divert those profits to itself. Eliot Spitzer compared these two tactics to "betting today on yesterday's horse races." I seem to recall gamblers calling this "past-posting"; see the classic movie "The Sting" for a tutorial. You'd be surprised how easy it is to win when you bet on races that already have taken place. All you need is a way to get the bet down. And although making the bet may not be illegal in itself, the things you have to do to get someone to take the bet probably will be. Canary found mutual fund companies that were willing to permit fund timing and late trading in exchange for capital commitments and fees. In exchange for benefits for themselves, they were willing to assign some of their investors' profits to Canary. The relatively open manner in which these arrangements were negotiated, documented and communicated to senior managers (who seem not to have taken exception) suggests to me that the people involved were more stupid (and/or ethically tone-deaf) than they were larcenous. Regardless, however, the schemes went forward, and the NY Attorney General says Canary made "tens of millions of dollars" in this fashion. (Two additional examples have come to light this week. A portfolio manager at Alliance Capital was suspended on suspicion of permitting late trading in his mutual fund in exchange for commitments of capital to his hedge fund, perhaps to increase the incentive fees in which he would share. Also, a former trader at hedge fund Millennium Capital pled guilty to engaging in after-hours mutual fund trading.)

Is This A Big Deal?

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The money Canary made from these machinations, while very meaningful to Canary, probably represents a "flesh wound" for the funds' investors. Even "tens of millions" wouldn't materially change the investors' return when spread over a number of billiondollar mutual funds and a three-year period. Spitzer's complaint cites an academic study estimating that these tactics divert $4 billion of profits per year from their rightful owners, the funds' long-term investors. Again, a large absolute sum but not material in relative terms: $4 billion equates to six onehundredths of a percent of the $7 trillion total invested in mutual funds – $6 per $10,000. On September 19, the Wall Street Journal cited research estimating that in the fund classes where fund timing might be most profitable, it could reduce investors' annual returns by 1-2%.

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So the damage done to an individual shareholder, or all of them put together, isn't enormously material relative to the amount invested, or even the annual return. And by the time the plaintiff’s lawyers subtract their fees, the damages won for the aggrieved parties aren't likely to be noticeable. It remains to be seen whether these tactics were widespread. In any case, I believe they're likely to be less so hereafter. The bottom line for me is that the Canary case, and the existence of fund timing and late trading, doesn't mean the mutual fund game is stacked against the investor. So does that mean the mutual fund industry is free from major shortcomings? I don't think so.

The Client Comes First!

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Just as in other corners of the money management industry, mutual fund companies face opportunities to make tradeoffs between their own welfare and the welfare of their clients . . . the two of which are far from identical. There's no question that the interests of clients should come first. Like lawyers, executors and trustees, money managers are fiduciaries. They hold positions of trust and owe a special duty to their clients. They are not supposed to "split the loaf" between themselves and their clients. Rather, the whole loaf must go to the client, in whose favor all conflicts of interest should be resolved. This is different from automobile sales, for instance, where it's completely acceptable – and universally understood – that the salesman will try to negotiate a higher sale price for a car in order to generate more revenue for his employer and more commission dollars for himself. Nobody's surprised to hear that car salesmen aren't fiduciaries. But besides being fiduciaries, mutual fund companies – like other money management firms – are for-profit organizations and marketing machines whose ultimate goal is to collect assets and make money. (There's at least one conspicuous exception: the Vanguard Group – whose Convertible Securities Fund we run – is a not-for-profit company owned by the investors in its funds). Jack Bogle founded the Vanguard Group and is a constant gadfly on the subject of mutual fund company behavior. In an article in the New York Times of September 14, he put it simply: The Investment Company Act says that the interests of fund shareholders must be placed ahead of all others, but the interests of managers have taken precedence.

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Who Protects the Clients' Interests?

In theory, a mutual fund is entirely separate and independent from the company that organizes it. The fund company doesn't "own" the fund or have the "right" to be its adviser. The directors of the fund are supposed to supervise the conduct of the fund,

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choose the adviser and revisit their decision annually. I would characterize this arrangement as largely a legal fiction. The website of the Investment Company Institute, an industry lobbying group, states the following: The directors or trustees of a mutual fund, as in the case of other types of companies, have oversight responsibility for the management of the fund's business affairs. . . . Under state law, directors . . . are expected to exercise sound business judgment, establish procedures and perform oversight and review functions, including evaluating the performance of the investment adviser . . . Directors also owe a duty of undivided loyalty to the fund. Overlaying state law duties is the fundamental concept of the 1940 Act that independent fund directors serve as watchdogs for the shareholders' interests and provide a check on the adviser and other persons closely affiliated with the fund. In my opinion, a number of significant issues surround mutual fund directors: 

First and foremost, I am highly skeptical of their collective performance, given that it is unheard of for a fund company to be terminated as the investment adviser of one of its funds. Have you ever heard of fund company XYZ being relieved of its duties as adviser of the XYZ Fund? From the fact that it never happens, we're supposed to believe that in every case the independent directors review the award of the management contract and conclude that XYZ continues to be the best possible manager for the fund. Can we possibly believe this process takes place? And that the fund company never deserves to be replaced?

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It seems unlikely that some of the directors in big fund families can know enough about all of their funds to make informed decisions. For example, the New York Times mentioned that the chairman of one fund board monitors 191 funds, and that a director oversees 60. How much can these directors know about the operation of each fund?

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There is good reason to question the independence of some of the funds' "independent directors." A good number of them are former employees of the fund companies. How likely are they to take away an advisory contract from their former firms? And how likely is an independent director to remain a director after he votes to fire XYZ as the manager of the XYZ Fund?

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Lastly, as in the case of corporations, there's the paradox of director compensation. Being a good director involves a lot of work, and it probably won't be done without a lot of compensation. But if the compensation is high enough, directors will want the job too badly to allow them to rock the boat. The board chairman referred to above was paid $816,000 last year. How likely is he to vote to fire the management company?

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The September 14 Times article included the following statements from observers of the mutual fund industry: Mutual fund directors sit on too many boards, and they are paid too much money for the time they devote to each individual portfolio. Under existing law the investment adviser is able to exercise a pervasive influence over the board. (Lewis D. Lowenfels, a securities lawyer at Tolins & Lowenfels) Directors certainly aren't doing much. We don't see much in the way of fee reductions – we see fee increases. When funds do terribly badly we don't see any management changes. We see directors' pay going up every year, and we see some pay that is just beyond the rule of reason, often paid to former executives of the management company. Fund boards only meet four times a year on average and they are still dominated heavily and intellectually by affiliated directors. (John C. Bogle) There were also a number of quotes from fund management company spokesmen: The Putnam trustees have a long record of independence. They were the first to have an independent nominating committee and the first to have an independent chairman. (John A. Hill, Chairman of Putnam's board) The Fidelity board always is conscientious and diligent in the service of the fund shareholders. We are proud to have on our board individuals who have the highest standards of integrity and business ethics. (Vincent Loporchio, Fidelity spokesman) Our fund directors are without exception distinguished leaders from business and government whose experience and insight serve our fund shareholders well. (Phillip J. Purcell, Morgan Stanley CEO and fund director) These protestations of diligence and independence would mean a lot more to me if the directors of these funds had a history of occasionally terminating the fund company as investment adviser.

Issues Regarding Marketing

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Ever since I was a teenager, I've heard that "mutual funds aren't bought; they're sold." In this regard they're like many other consumer goods. People don't decide they need them and figure out which one is the best. Often, rather, people are convinced to buy mutual funds through salesmanship. Mutual fund families are money-raising machines. They include some of the best marketing companies in America. But some of their excellence serves to enhance their treasuries at the possible expense of their clients.

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

Of course, the industry stands for the delivery of active investment management to the masses (although some firms also provide passive management through index funds). Sales are achieved on the basis of comparisons against other mutual funds. Little is said about the long-run ability (or inability) of funds to beat the market.

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Some mutual fund families offer so many funds, of such an amazing variety, that it's not illogical to wonder whether their motivations don't include a desire to always have something in the top quartile, and something to advertise with four stars.

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The funds in the bottom quartile, on the other hand, have a striking tendency to be merged out of existence – causing their performance records to disappear.

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The industry can be criticized for hyping (and selling) funds in whatever market sector is "hot." Certainly we don't see any warning labels to the effect that "hotness" can be synonymous with elevated prices, and thus with the potential for subsequent losses. The mutual funds that were on magazine covers during the tech bubble buried their clients. It's not a coincidence that the average fund investor does worse than the average fund; it's because investor money is constantly being lured into the funds that have been performing best, and thus are the most precarious.

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Lastly, compensation arrangements at mutual fund sales organizations can be adverse to the clients' best interests. For example, there may be incentives to steer capital to a brokerage house's in-house-managed funds as opposed to selling competing funds – because a dollar invested in an in-house fund brings the firm more profit. Once I described a fund to a marketer in terms of its current yield, yield to maturity and yield to call. He said, "Forget about that; let's talk about the thing that matters most: YTB" . . . meaning "yield to broker." There was no doubt where his motivation came from.

Issues Regarding Expenses

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Most mutual funds operate in "efficient markets," where it's hard for one portfolio manager to get an edge versus the others. It's rare in the long run for any fund to beat its market benchmark or the other funds of similar riskiness in its niche. In efficient markets, expense minimization is the surest route to better net results, and it's for this reason that Jack Bogle pioneered the creation of index mutual funds. The performance of an index fund is certain to mirror that of the market, and expenses truly are minimized. But almost all mutual funds are actively managed, and their expenses are anything but minimized. 

The average mutual fund carries investment management fees far above those paid by institutional investors, even those investing far smaller amounts of money.

2003 Oaktree Capital Management, L.P.

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The administrative expenses borne by the funds are high and, most significantly, have not demonstrated a tendency to decline in percentage terms as the size of funds has increased. That is, they haven't reflected any economies of scale.

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Many fund shareholders pay continuing marketing charges. Why should the costs of selling funds be borne by the shareholders? The usual response is that a bigger fund benefits its shareholders. But then, shouldn't increasing size result in a declining expense ratio?

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Even as the total assets of the top 25 equity funds were increasing 845 times over the last 51 years, the average expense ratio rose from .64% of assets to 1.50%, an increase of 134%. (Source: "The Mutual Fund Industry in 2003: Back to the Future," by John C. Bogle)

As the total assets of the top 25 equity funds grew from $2.2 billion in 1951 to $1.9 trillion in 2002, the charges for managing and administering a dollar of assets more than doubled. One wonders how many of the "diligent, independent" directors resisted those increases.

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Are mutual funds good for America? In delivering market participation to retail investors and capital to America's companies, they're invaluable. In hyping hot investments and charging high fees for modest performance, they provide no great service. Are mutual funds safe vehicles for investing? They're no safer than the markets in which they invest, or passive funds. But cost aside, they're not much worse. Are mutual funds scandal-ridden? The Canary Capital incident doesn't worry me, but I think the long-term structural issues discussed above are very troubling. Mutual funds are a good thing overall, and they could be made even better. But that will require a conscious decision to always place the interests of fund shareholders above those of the fund companies. In many cases, that's going to take a while.

October 2, 2003

2003 Oaktree Capital Management, L.P.

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