Where are the portfolio
managers' yachts?

In his 1930s book, Where are the Customers' Yachts?, former broker Fred Schwed gave the inside scoop on the Wall Street of his day. The title refers to an old Wall Street tale of a young broker, who, when shown the investment bankers' yachts moored at the foot of Wall Street, naively asks, "But where are the customers' yachts?"

In this column we often address securities that are poor rewards for the risks entailed. These are bonds designed to provide yachts for the issuer or broker, but not for the investor.

This makes us wonder, what about the portfolio managers who make all the best risk-reward decisions? Do they in fact contribute significantly to the bank's bottom line? If so, where are those officers' yachts? And, if it is possible to obtain higher returns by investing more knowledgeably, should there be performance-based compensation for portfolio managers?

Returns, not yield
Before performance can be rewarded, we must decide what constitutes good performance. One of the most common measures of performance is to compare portfolio yield versus peers' yield. This might make sense over longer periods of time. However, over the short term such a measure can lead to intentional, and more commonly, unintentional excess risk taking in order to prop up the income statement. As regular readers will know, we believe yield is generally a faulty measure and prefer total return.

An extreme example demonstrates the principle. Consider Bank A, which purchases a 7-year callable 3 agency security in 1990 at an 8.83% yield. On the same day, Bank B buys a noncallable agency that offers less yield-8.53%, to be exact. For three years, Bank A out-incomes Bank B. But in 1993-you guessed it-Bank A's bond gets called away, and is replaced with a new 4-year agency yielding 4.92%.

The first poor decision here was selling a call option for 30 basis points. For three years this tack dressed up Bank A's portfolio income versus Bank B, but for the last four years, Bank A will receive 4.92%, while Bank B is still earning an 8.53% coupon. That represents a spread of 361 basis points. Over the life of these two strategies (7 years), Bank B will outperform Bank A by more than $150,000 per $1 million invested.

The explanation lies in the market value of Bank B's investment and in the lack of appreciation in Bank A's investment. Because Bank A's bond was callable, it could not appreciate as much during the decline in interest rates from 1990 to 1993. Meanwhile, the valuable noncallable bond, with its 8.53% coupon, was rising to the point in 1993 when the callable bond was called at par and the noncallable bond was worth more than 112 cents on the dollar.

We've given many examples in this column over the years of using total return to measure real outcomes in your portfolio. But how much can one expect to improve an average portfolio using high-performance portfolio management skills-that is, portfolio management that knowledgeably quantifies potential real-dollar results in advance, whether rates go up, down, or sideways?

Top pay for top investment performers
While we know many portfolio managers who earned total returns from 100 to 130 basis points above the average, those who we would qualify as high-performance managers have also outperformed the average bank consistently, regardless of whether rates went up or down. In other words, anyone can have a view of rates and be long or short, but how many portfolio managers seem to come out on top no matter where rates go?

With the help of IDC Financial Publishing, authors of the Investment Portfolio Digest, we studied call report data and IDC's total return calculations based on call report data. We found that there were 962 banks (out of 9,280 measured) that were in the top 25 percentiles for not only the last year, but for the last 3- and 5-year periods. On average these portfolio managers earned more than 100 basis points over the median bank last year. That's $100,000 for every $10 million in your portfolio.

How were these portfolio managers compensated? In a recent meeting of high-performance portfolio managers, we asked, "How many of you who are averaging more than 100 basis points better performance than average got a sizable raise last year?"

We'll put in our two cents. Say your portfolio manager really knows what he or she is doing and is consistently performing between the 50th and 90th percentiles on a yearly basis-as opposed to someone who takes a lot of risk and goes back and forth between the 90th and the 10th percentiles. This puts your manager in the top 25th percentile on a 3-to-5-year time horizon.

Looked at in that way, your portfolio manager should be earning six figures. Now, you might say, "Our portfolio is only $20 million." Then either you can't afford your portfolio manager or he or she is only one offer away from managing a portfolio that can pay. That portfolio manager brought in an extra $200,000 over the average portfolio manager last year. Maybe you can't afford not to increase that officer's pay.

"Where are the portfolio managers' yachts?" we asked at the top of our article. We have noticed that when these high-performance portfolio managers are the presidents of the bank-and usually the owners-their yachts can be found on lakes and oceans throughout the country.

But when the portfolio manager is in a non-ownership management position, we see them many times being less appreciated than their loan-side peers. Yet as the IDC numbers show, there is a direct correlation between banks' long-term total returns and their actual realized returns (income received plus or minus gains or losses actually taken and reported through the income statement).

Pros and cons of performance pay
Performance-based compensation is seen as a key to increased productivity and profitability in almost every industry, as well as in many banks-in areas besides investment management.

How would this concept work in the investment portfolio? In some bank situations, a direct link between total return and compensation could be established. If this were done, we believe it would be advisable to base them on 3-to-5-year results.

Don't base compensation on short-term results. If portfolio managers can take big short-term risks and see a big check if they win, some will take that risk. More times than not, because the strategy was out of line with the institution's best long-term interests, everybody loses-and dramatically, if the portfolio manager's bet loses.

Most often, we believe, portfolio managers' pay should continue to be through flat salary; there should just be more of it for the truly competent ones. Perhaps long-term results could be rewarded through a performance-based bonus formula.

Some banks will object to comparing their portfolios' performance to other banks'-we addressed that in our April 1997 column, which introduced our monthly Betzold Berg Investment Portfolio Index. In general, we think most banks can make a fair comparison to the average bank. There will be some exceptions. One example is those states where there are special tax issues. However, a universe of similar banks could be used instead of the median of all banks, which we have referred to here.

Ultimately, it is in your shareholder's best interests to have a motivated, educated, knowledgeable, and competent portfolio manager. For some, performance-based pay may be the "paradigm shift" needed to accomplish better future performance. But for some of our bank readers, you might need to address this yacht issue more seriously.

Or you may see your portfolio manager in a yacht...on your competitor's lake! BJ