The Peril of 'Performance' Investing

Key Insight

The 'performance' cult emerged in investment fund management, attracting considerable attention despite involving a relatively small sector of the industry. These funds aimed for significantly better-than-average returns, achieving initial success that generated publicity and attracted substantial capital. However, this objective proved unsustainable without incurring sizable risks, which eventually led to losses. Many of these 'brilliant performers' were young, in their thirties and forties, with direct financial experience limited to the continuous bull market from 1948 to 1968. Their investment strategy often equated a 'sound investment' with a stock expected to rise sharply in a few months, leading to large commitments in newer ventures priced disproportionately to their assets or earnings, justified by speculative hope and exploitation of public enthusiasm.

The Manhattan Fund, Inc., organized at the end of 1965 with $247 million, exemplified these perils. It focused on capital gains, investing in high-multiplier, non-dividend-paying stocks known for speculative following and dramatic price movements. After a significant 38.6% gain in 1967, compared to the S&P composite index's 11%, its performance deteriorated markedly. By the end of 1969, two of its largest investments filed for bankruptcy within six months, and a third faced creditors' actions in 1971. A striking disparity was evident in the outcome for investors versus management: the fund's founder-manager sold his stock in a separately organized management company for over $20 million, even though the management company itself held less than $1 million in assets at that time.

A broader trend was observed among 'top' money managers profiled in 'The Money Managers,' who showed strong performance through 1968 but reported losses in 1969 and even worse comparative results in 1970. This illustrates a recurring historical pattern where energetic individuals promise 'miracles' with 'other people’s money,' achieving temporary success only to eventually bring losses to the public. While flagrant manipulation practices common in the 1920s were banned, new 'gadgets and gimmicks,' such as buying 'letter stock' below market price and reporting it at full market value to create illusory profits, achieved similar detrimental outcomes. Sustained outstanding results in performance funds are strongly correlated with smaller fund sizes, with an average size of approximately $60 million noted for some top performers in 1967, suggesting that large funds, even when well-managed, can at best achieve only slightly above-average returns, or spectacular but inevitably calamitous profits if managed unsoundly.