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Portfolio > Asset Managers

Taking the Really Long View (Longer Version)

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When Rob Manning goes to work every day, he’s got big shoes to fill, since he oversees the first mutual fund, Massachusetts Investors Trust, which this year marks its 85th anniversary. We spoke with Manning, the CEO and CIO of MFS Investment Management, by telephone on June 1 to learn what MIT and its parent company can teach us.

Please talk about the history of Massachusetts Investors Trust and the MIT approach when it comes to the role of the mutual fund in investing. Obviously we are biased and believe mutual funds are a great vehicle. Here at MFS we have an 85-year history of running actively managed, open-ended mutual fund pools. One of the threats that has come up in the past five to 10 years has been indexing through ETFs, as well as alternative investment strategies. We have been competing against indexing for generations long before ETFs proliferated. The only advantage that an ETF gives you over an index fund is that you can trade it intraday. If you want to get exposure to a market it shouldn’t matter whether you do it intraday or at the end of the day or at the end of the month. The important thing is that you are going to get the market return minus whatever the embedded costs are in that instrument. We believe, and we can show you statistics on our performance, that an actively managed portfolio, even with the expenses associated with it over the course of a cycle, if you do it well you generate a lot of excess return for the risk you are taking for a client.

On the other end of the spectrum we have this proliferation of instruments, and that has not worked out well–everything from the Bernie Madoff scandal to fund of funds managers, to some hedge funds closing their doors and shutting redemptions down because they weren’t able to handle liquidation. That really plays into the strength of MFS, which is that we are very large global company, around for 85 years, owned by Sun Life of Canada, no debt on our balance sheets, we operate under the most strict regulatory schemes in everything that we do.

We are a firm that has board oversight and governance that is best-in-breed and an environment where people are concerned where their money is housed and more importantly what the manager is doing with that money in terms of staying true to the style.

Firms like an MFS we think are going to come back into vogue in the next cycle because of the safety, the liquidity, but more importantly the investment framework that has allowed us to outperform passive products and the competition in the actively managed space. An active manager who can prove they add value over time will still be able to thrive and do well in the world we are going to be living in, which is probably going to be a slower economic environment with less leverage both at consumer and corporate levels.

With the regulatory schemes we are going to see come out of this, a manager better have scale in compliance and the governance associated with all those elements in order to protect people’s money. Some of the alternative investment strategies, which are one-man shops run out of a house or a small office, are going to have a very hard time competing in this world because people aren’t going to trust them.

Many advisors that I have talked to, are looking hard at what their assumptions are about the markets and the best way to invest on behalf of clients. Do you think that questioning things like asset allocation and Modern Portfolio Theory is the right thing to do? At the point in time where there were so many uncertainties in the systems, where people were just concerned about the solvency of the financial infrastructure in this country as well as around the globe, I think the Central Bank actions to prop up the capital of many of the large financial institutions as well as the nationalization has taken that apocalyptic outcome off the table. Now people see that the world isn’t going to come to an end, it is going to look different, as I think I said, it’s not going to have the growth in the economy globally due to the regulations, the lack of leverage in the system, consumers aren’t going to be allowed to borrow the way they did. Ultimately I think it is a good generational change that people, especially in the U.S., are beginning to save and not consume all the time, because I don’t think that’s a healthy way for society to operate.

So I do think that, as we look back, history always does repeat itself, we’ve had a bear market, we’ve had a deep recession, we will come out of it, growth will resume, capital markets will recover. It’s not going to be a straight line, there will continue to be some volatility, but I think that worst case scenario has been removed, and that moving forward I think that the capital markets wont visit those lows that you just documented.

In terms of asset allocation I get asked this question a lot, and I think people need to go back to disciplined asset allocation; that’s what was missing. People’s expectation on equity market returns were completely out of the realm of reality, and in fact many people in their 60s, 70s, and 80s, because of longevity, believe that they should throw asset allocation and Modern Portfolio Theory out the window and be more heavily exposed to stocks because they were always going to go up more than fixed income instruments would. People went way out over their skis, whether it was in their 401(k) plans or personal savings, and lo and behold bear markets do happen, recessions do happen, dislocations happen, and equities are much more risky than Treasuries or high-quality fixed income instruments.

The lesson to be learned here is history does always repeat itself, that there are tail events that occur in capital markets that you can’t anticipate, and you have to look at asset allocation, you have to look at rebalancing your portfolios, you have to be diversified, you have to own not only cash-like instruments and non-correlated instruments to the equity market, you’ve got to own fixed income.

I was on CNBC and Sue Herera asked me about asset allocation, that it doesn’t mean anything anymore, everybody got killed. I said, well, if somebody owns Treasury bonds they are up 25%. You have to go back to the efficient frontier, modern portfolio theory, your age, you expectation on income, and the volatility and risk you’re willing to assume for the returns that are available in the marketplace. I think that firms like MFS can help clients such as reps and financial advisors not only by doing a good job in the styles that we’re hired to manage, but also through some of our asset allocation and target date products, where we manage that aspect of the allocation process with sophisticated models, looking at historical volatilities and returns to provide the optimum point on that efficient frontier for a client to be in.

To flip this whole thing on its head, I think people need to not throw out MPT and asset allocation but they need to go back and read the books and actually do what they said you were supposed to do. I think its back in vogue, and this is a great, particularly for those who are younger as an example of what to watch out for. I don’t think the equity-oriented culture of having so much exposure to one asset class can thrive in the future, and hopefully the next generation will learn that.

The Depression affected people who lived through it for decades afterwards, Is tempering the expectations of investors something that all professionals have to remind investors of, but also maybe that might be a good thing that come out of this? Yeah, the most durable wealth I’ve ever seen built by any individual is over a long, long period of time. If it comes too quickly you’re likely to make errors and give it all back. People do need to ratchet down their expectations of equity market returns. The studies which were the longest dated series of data we have show equity markets return 7% to 9% on average, and so, yes, you should own some equities, This is probably a good time to actually buy equities although people are afraid, but you also need to own some fixed income, you need to own high-grade credit, which right now if you buy some BB and BBB bonds in a basket you can get 8% to 9%, which is historically what the equity market has returned.

So even though there is a dislocation and people have been burned by what’s happened, there’s also wonderful opportunities to invest in markets right now that are giving you outside yields or returns to the risks you are taking. I would also argue that rates on taxes are going to go higher in the next few years and we can obviously point to the factors driving that. Municipal bonds actually yield more than Treasuries, which is an anomaly but also a great opportunity. So in all of this turmoil and dislocation and pain and anguish, there are great opportunities that exist in the marketplace today for those who are willing to open their eyes and be patient.

We’re probably in quite a recovery as we speak, and I don’t know what the market is going do from week to week or year to year, but I think you have to get back to a single-digit expectation of return from stocks. I think people who build their models and their asset allocations on those expectations are going think differently than they have in the past.

If that’s the case, should there or will there be more emphasis on the tax efficiency of investments or on the expense ratios of a given fund? I just think it is a factor, and its really the taxes that create the inefficiencies in the marketplace, for instance with munis where if you wanted to buy high-quality fixed income instruments, don’t buy Treasuries, buy munis, because you can buy AAA munis that yield more than Treasuries. I’m really not getting at the tax aspect of it, because everybody always thinks about managing that expectations, I’m really talking about the anomalies driven off increased taxes and some of the markets that appear to be cheap as a fallout of all of this. In negative terms, most equity mutual funds won’t have capital gains for many, many, many, many years. So it actually makes them much more competitive against an ETF because they have embedded losses in them. So the good news coming out of the backside of this if you’re investing now in an equity fund, it’s unlikely that any gains are gonna get paid out on them.

Now the one thing that we should talk about, because I alluded to it in my earlier comments around active management and the MFS story, is how we’ve been able to perform. You’ve probably seen these numbers but over a three- and five-year period, 90% of our funds in the family are above their category average, and 63% of our assets get four- or five-stars fromMorningstar. The way that we manage money here is very unique, in one of the questions you asked whether we look at balance sheets differently now [in considering stocks or bonds for inclusion in a portfolio] and how we do it,

MFS has a global research platform with analysts all over the world, they operate in sector teams, we break the world up into eight sectors. We are looking at everything from the balance sheet and how the credit people look at the story, to what global companies that operate around the world are experiencing, because we have people on the ground in different geographies around the world and we’re looking at relative value and analysis and understanding all the inputs that are required to make good investment decisions.

For instance, our equity people know where the credit default swaps are trading on all of these companies because our fixed income people are sitting in the room with them, and our fixed income people get the global exposure of our equity analysts located around the world to try to understand opportunities and risks that exist,

I do think that people are going to do analysis different, particularly in actively managed funds as we do, and I think having a global perspective is going to be key, because as we’ve seen in this recent financial meltdown nobody was immune to it, everything was connected, all these instruments were helped by the same financial institutions located around the globe.

You have to have that global footprint, but more importantly you have to integrate all of these different disciplines into one team that can look across the spectrum of everything that is going on and make good investment decisions. We think that our global research platform…we don’t think anybody else has it the way that we do it, It will be the model that people use.

People have analysts located in regions around the world, but they typically have their own portfolio management teams, they operate in isolation, and don’t think in terms of helping one another in all disciplines, as I mentioned like fixed income, domestic equity and international. So that global research platform is why we made it through the storm better than other people and we think that that will be the model that most active managers move to overtime, if they can figure it out. But it’s very expensive to build it out, and we have the platform that we’ve invested in over several decades, and it’s one of the reasons why we were able to get through the storm in pretty good shape.

It sounds like you need some serious scale in order to do that globally, is that fair to say? I think you need the scale, the investment to do this is substantial. But more importantly what you need is a culture of cooperation, and that’s not something that money can buy, it’s done through time, its done through compensation structures, and its done through attitude of the senior leadership team on the investment side, and the type of people that you bring in and their belief in that system. It’s more than just money.

And that starts at the top? I started out here as an analyst, and we believe that any asset management firm, particularly a global asset manager, should be run by an investment person, because ultimately that’s what drives the firm and you need to have someone who understands the investment process, is able to send a consistent message to the people that you are not only bringing into the firm but who are here today, what the expectations are. How you are going to generate alpha? How you going to structure yourself to be able to do that in the cultural elements that I described being enforced through everything from compensation structure to the way that everyone does business on a day-to-day basis.

Would you talk about the compensation structure, how it works, and what you think it delivers in terms of culture and attitude? The most important thing is that we think long term here. When we are appraising someone’s performance, we take a three- to five-year time horizon, assuming they’ve been here that long, and assessing whether or not that person is delivering value, and we want people thinking out two to three years when they make an investment. We do that because there’s a lot of short-term noise in the marketplace, and we think one of the competitive advantages you can have is to be longer term in the way you invest; that’s the arbitrage on the opportunity. First, we weigh long term performance significantly more than short term, in fact one-year numbers are really meaningless to us as a firm. Second, in our compensation structure a third of people’s comp is derived from a 360 degree peer review that is done twice a year, where traders are rated by analysts and portfolio managers, and portfolio managers are rated by analysts and traders and all the members of the team, because what you really are trying to do is not only have smart people that are generating value, but making sure that their knowledge and the value they are delivering is being spread across the platform and helping everybody become better at what they do.

The only way you can make this global platform work is to have everybody not only buying into and believing it, but understand that if they don’t participate and help other people on the team that it is going to hurt them in terms of their compensation. So we’re one of the few firms that actually does this, so if somebody is a portfolio manager here and they’ve done a good job here making portfolios, but they’re not talking to anybody else or helping the section teams and making the whole team better, they’re not gonna be the highest paid person at the firm. We designed it this way so that we compensate people around their ability to share information, mentor younger people, and help the whole team become better, not just themselves.

That’s the key. You want teamwork and cooperation. Often times, and we’ve done this, we’ve hired really smart, talented people, and they can’t get it, they won’t do it, and we ask them to leave. So it’s like having a superstar on a basketball team that’s completely obnoxious and doesn’t pass the ball: the team isn’t going to win. That person may score a lot of points individually and win awards for doing that, but that doesn’t mean that the team is going to be successful.

Are the advisors, who I’m sure are an important part of your distribution network, asking different things of you? Do they want to meet the managers more, are they asking for more research from you? How is that relationship going and has it changed over the past 18 months or year or so? Embedded in that is a very important question, which is that the advisor has to build their business just like we build a portfolio. It’s got to be protected on the down side and it’s got to be thoughtfully constructed. I think advisors need firms like MFS that can help them solve their client’s problems through products that we deliver, but more importantly create a relationship with the firm they can trust, that they think will be with them through thick and thin, deliver good value for them and their clients over time, but be a partner that’s gonna be around and be durable. A firm like MFS that has an 85 year history, with a very strong ownership structure, no debt, not a public company that is under pressure to do short term things that can affect the business for the long run, is really something that most advisors want to partner up with, and in times when its easy and you’re making money just cause markets are going up, you can forget who your friends are and who you should be partnering with and things that protect the downside, and I think what we’ve gone through is that firms that are structure like MFS that have the resources we do can be helpful in building a business for the long run which is really the key. So we don’t come out with hot products that we don’t think we can manage well or are good for the client, we focus on providing materials and information, asset allocation products that really help the advisor make good decisions for the clients depending on their risk tolerance and being there for them during difficult times and help them get through these times. So we do have one of the largest field forces in the mutual fund business, these are our distribution people located in different geography around the United States. We do seminars to help advisors understand what’s going on in the market. We do calls, we have a great website that provides information. We have a chief market strategist, Jim Swanson, who travels around the country, meets with advisors, does webcasts as well. I think its our responsibility because the advisors are our clients who have their own clients and we better do a good job helping them to build their business to a long term relationship, and that’s what we’re focused on.

When you were talking about having a long term view does Sun Life of Canada, that ownership, does that help in the respect that they are not looking for just great returns in this quarter, that sort of approach goes through the company culture-wise? Oh absolutely, we’re blessed to be owned by Sunlife, they’re I think the 5th best capitalized life insurance company in North America, very conservatively run, long term oriented, they’ve owned us since 1982. I think the most important thing is, when I describe that global platform that we have both on the distribution and research side, they paid for that, they helped us get the capital over the course of many, many years to build that out, which is really the jewel of the company that we think is going to launch us into the future from a competitive point of view that differentiates us from other people. There’s no way if we were a public company, that the markets would have been patient enough to allow us to make those investments which took many, many years and energy and time and margin to develop. We’ve been in Tokyo for ten years now and we just turned profitable. So we lost money for ten years building out our Tokyo operation. If we were a public company the markets would never have been that patient. So it is a great blessing, and the infrastructure and the platform we have today, and unless somebody’s got a lot of capital and a lot of patience they can’t get what we have cause of what we’ve been able to do over the past 20 years in our relationship with Sunlife.

Do you expect there to be further consolidation either in the funds industry or in the asset management industry in general, folks who are already, those with margins are seeing them squeezed pretty tightly, just as these advisors are seeing the same problem? Yeah I do think you will see particularly subscale players, subscale being less than 100 billion in assets, talk with one another about how to marry together to get larger scale and size. I also think on the upper end you will see some very large asset management firms break themselves apart because it is very difficult to generate alpha when you are managing hundreds of billions of dollars in assets you cannot move quickly and you become so large relative to the market caps you’re investing in that’s its tough to develop relative performance. So we are also blessed that we are about 150 billion or so in assets and we are to scale, we have a global platform that will continue to grow, we have positive flow as we speak and we think that we don’t have to do anything, it is not our strategy to do anything on the acquisition front and our goal is to organically grow and deliver goodvalue for our clients and not be distracted by an acquisition or an integration of something, or being confused by making a strategic move that would disrupt what we are doing. So, MFS is an organic, simple, boring story, and our parent company continues to believe that we are a great business to own and they want to own us for a long, long time and they’re investing capital in us to continue growing business

Are there any points you want to make about the business in general? I think a lot of people are doing soul searching, and this is a period in time where quality, not only in the types of companies that you buy in your portfolios, but in the types of the companies that operate in the marketplace are what’s going to determine success going forward, and we will get through this environment which is a unique challenge.

Although it is a recessionary period and there has been a lot of dislocation, none of us have seen anything like this, but our system is flexible, it is healing, the world is going to recover, but people just need to think differently about the future when they invest and they need to protect downside. I think people will get back to old-fashioned investing, where you are asset allocating and rebalancing over time depending on what’s going on in the market place, and they’re going to want to do it with companies that have staying power, which have a brand, that have the infrastructure and will keep them out of trouble


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