Keeping the Pressure on Portfolio Managers: A Tangible Benefit of Fund Trustees
Written by By Jack Treynor, Independent Trustee, Eaton Vance Funds   

(Mr. Treynor has long argued that portfolio managers should do what they are paid to do - trade based on their skill rather than wait for their luck.)

The true style of your fund group's portfolio managers runs much deeper than simply understanding if they are growth or value disciples. Beyond their apparent investment acumen, portfolio managers' mindsets often determine when, how and why they trade a fund's portfolio. A fund trustee needs to understand the portfolio manager's frame of mind.

Assessing fund performance and the quality of your group's portfolio managers is a key part of your overall responsibilities. But how can you tell -- really tell -- what motivates your funds' portfolio managers to action or restrains them from taking any action? A fund trustee can often peel back the layers and get a glimpse of the "real" managers at the helm.

In measuring fund performance, rate of return by itself means nothing. To determine your management's contribution, you have to measure each fund's sensitivity to broad fluctuations in the relevant market segment, which many refer to as "beta". Observe what that market segment has done over your sample period and remove its effect on your fund's rate of return. Has some, most or all of the fund's return been due to the changes that took place in that market segment? Do not give credit for a rising tide.

As a trustee, you should look for clues. Subtle things such as posture, dress codes and the physical organization of the office can offer valuable evidence to the way investment and trading decisions for your funds are really made.

Fund managers who are "bargain hunters" are engaged in comparisons between alternate investments. An independent trustee should ask: Are their comparisons based on a consistent analytical framework, with the same macroeconomic assumptions and the same valuation philosophy, whether they analyze steel, semiconductor, or cosmetics companies? Ensuring that all of the analysts and portfolio managers march to the same drummer requires organizational discipline and the authority to enforce it. A top-down organization and unified mandate are imperative.

If your managers are "bargain hunters", do they understand that the best estimates are, in fact, an average of many independent opinions? Thus a stock price is most reflective of economic reality when it is independently derived and not swayed by a common influence like an article in Forbes or The Wall Street Journal. The most accurate market prices are those of stocks neglected by Wall Street analysts.

Conversely, for "information traders," consistency is less important than the kind of creativity that emerges when people have the courage of their convictions and do not hide behind the reasonable, the plausible, and the popular. The sad truth is that most large organizations do not focus on developing these kinds of people.

As a trustee, watch closely for signs of personal growth among your firm's "information traders". Portfolio manager presentations to the Board or Investment Committee offer the best opportunity to watch these people strut their stuff. Do you see visible growth in individuals from year to year? Intellectual excitement? Insatiable curiosity? Or merely exuberance. Do your firm's "information traders" understand the "common sense" rule? That is, if an investment idea appeals to their common sense, then it is already reflected in the price, and that they may be incurring the cost of trading unnecessarily.

After all is said and done, the trading game is zero-sum. The counter-party in their trades cannot win unless they lose and that your managers cannot win unless the counter-party loses? If a seller wants out, it is a good bet the seller knows something that is not yet imbedded in the price of the security. If it's good news, it will not become apparent until after you have sold. If it is bad news, it will not become obvious until you have bought. The enduring point for a fund trustee is to be sure that your portfolio manager does not have a habit of buying just because the seller is offering something that seems too good to be true.

There are two types of risk inherent in portfolio investing -- the risks of holding securities and the risks of trading securities. Inevitably, most of the risk (which play out as good surprises or bad) will happen to the securities in your funds between trades. It is the same risk whether the management of your fund is active or passive, quantitative or qualitative. Are your portfolio managers wed to the securities they've bought? Are they passionate -- perhaps too passionate -- about holding stocks, when they should be seeking new opportunities?

Accordingly, there are two games: a poker game with trading counter parties, and a game of chance, in which all investors, amateur and professional play on equal terms. Do your managers focus their energy and attitude where it mattersóon the poker game?

Regarding games of chance, most important investment news is as hard to predict as the turn of a roulette wheel. It is counterproductive to exercise the sort of 20-20 hindsight of which the financial media are so fond. Unfortunately, fund directors are exposed to the same media as everyone else. If they come to board meetings all steamed up about management's failure to anticipate something nobody else anticipated, they can disrupt a board meeting and demoralize portfolio managers and analysts. It is human and natural to judge the old view from the vantage point of the new, and condemn it as wrong, or even stupid. In this important respect, fund directors need to be better than merely human. A particularly virulent form of hindsight is criticizing a high market risk fund for under performing when the market is falling or a low market risk fund when the market is rising.

Trading shares is a sophisticated skill, where emotion and logic intertwine. A mutual fund trustee has to understand what motivates a portfolio manager, what organizational discipline is exerted, the motivation of the compensation package as well the consistent application of the investment objective as stated in the fund prospectus.