Confessions Of A Fund Pro A manager explains how the deck is stacked against you.
By Jason Zweig; Ted Aronson

(MONEY Magazine) – Over the years, I've interviewed enough portfolio managers to fill a couple of Boeing 747s, and it's gotten to the point where there's very little that any of them can say to surprise me.

Then I met Ted Aronson. He runs Aronson & Partners, a firm that manages more than $2 billion for big investors like Ameritech, the Florida Retirement System, the MacArthur Foundation and New York University. Normally, you need $25 million to invest with Aronson, but he and his partners, Kevin Johnson and Martha Ortiz, also manage a mutual fund, Quaker Small-Cap Value, which was launched two years ago and has just $11 million in assets and a $10,000 minimum.

Aronson, 47, has been managing money since 1974. He works out of a converted duplex apartment in an old building in downtown Philadelphia. Unlike most money managers' offices, this one's not decorated with giant abstract paintings and stiff mahogany furniture. Instead, there are plenty of soft places to sit and walls papered with antique stock and bond certificates to remind you that many popular investments fail. Aronson's sense of humor and perspective is evident even at the office postage meter, which stamps outgoing mail with the slogan, "Don't confuse brilliance with a bull market."

Few fund managers would volunteer such a self-deprecating thought. Aronson, however, can hardly open his mouth without challenging conventional wisdom.

Q. You've said that investing in an actively managed fund is an act of faith. Why?

A. Under normal circumstances, it takes between 20 and 800 years [of monitoring performance] to statistically prove that a money manager is skillful, not lucky.

Q. Did you say 800 years?

A. That's right. To be 95% certain that a manager is not just lucky, it can easily take nearly a millennium--which is a lot more than most people have in mind when they say "long term." And let's say, after a mere 20 years or so, you finally get to the point where you can say to us, "OK, Ted, Kevin, Martha, you're it, you're great"--then the whole thing changes. I retire, Kevin loses his mind, Martha becomes an alcoholic, we sell our firm to United Asset Management and take on $10 billion when we can only manage $2 billion. I'm kidding about us, but that's how the money-management business really works. It's a stacked deck. The game is unfair.

Q. Is picking a good fund manager completely hopeless?

A. Not completely. Start by looking for a very low fee structure. Then ask whether there's a finite amount of assets that the manager can run in his style and whether he's committed to limiting the fund to that size. Also, if the firm has an edge, ask why it should endure. If the moneymaking machine is inside one person's head, your risk is that person's life span--or the chance that he'll go work for someone else.

Q. What's your investment philosophy?

A. There's a cartoon that shows two lions on a hilltop, and one says, "I'm not picky--whatever's wounded." Over time, I think the stock that's wounded--that's out of favor in the market--will outperform.

Q. Your fund was beating the Russell 2000 index by five percentage points in late 1998. How?

A. I wish I could say it was because we are geniuses. The truth is almost embarrassing. We got inflows of cash [from new investors] in the extreme downmarkets of April, July and August. When the market is down, any cash sitting in the fund from the night before makes you look like a star.

Q. Why don't more funds beat the market?

A. Because they can't.

Q. Why not?

A. Costs. Funds charge annual expenses of 1% or so; then it costs them another 1.5% to 2% to buy and sell their stocks each year. And there's something else: After three or four years of this water torture [lagging the S&P 500], active managers haven't gotten smarter. If anything, they've gotten stupider. They're scared. They're like cowering dogs. It's hard to imagine them doing anything but just following the crowd--because if they don't mimic the index, they'll get beaten by it again. A lot of people think active managers will outperform again when small stocks do better than the S&P 500, but there's nothing written in the Scripture that says it can't go on like this for our natural lifetimes.

Q. Doesn't history prove that small stocks outperform large stocks over time?

A. That's a crock. The costs of buying and selling small stocks are a lot higher, and the averages don't reflect that. The extra trading costs easily eat up the extra return--and then some. But with a "whatever's wounded" philosophy, you should look at small stocks today precisely because they're so out of favor.

Q. Do you accept Wharton Professor Jeremy Siegel's contention that stocks have returned an average of 8.5% annually since 1802?

A. I love equities, I'm not a weirdo and I don't live in a bomb shelter. But in a very real sense, the compounding of stock returns over long periods is a fraud. It really is. No one has ever gotten those returns. Prior to the birth of index funds 25 years ago, the man on the street had no reliable way to earn the stock market's average return. And in 1802, the total value of all the stocks in Jeremy Siegel's index was around $3.5 million. If you compound that at 8.5% annually for 196 years, you get $30.8 trillion. Yet the total value of the U.S. stock market today is only $10.7 trillion. So where did the other $20 trillion go?

Q. You tell me.

A. It went up in smoke. People bought good stocks that later went bankrupt, like the Philadelphia Guano Co. that's helping to paper the wall in our bathroom here. They bought bad stocks that never were included in any index. They took money out of stocks when they needed cash. They spent their dividends instead of reinvesting them. They sold everything during market panics, and they didn't get back into the market until after it had gone back up. They didn't buy and hold, they bought and sold. That's why this religious belief that stocks return 9% or 10% or 11% over the long run is just...guano.

Q. Professor Siegel says much of the difference comes from the lack of dividend reinvestment.

A. He's absolutely correct. And that's why it makes no sense to assume anyone will earn that kind of return in the future. You have to subtract from the historical averages any portion of the return--fees, taxes, dividends--that isn't reinvested.

Q. So stocks are a bad idea?

A. Absolutely not. I think over 10 years or more stocks will outperform bonds, bonds will outperform cash and all will be right in the universe. But I could see flat [stock] returns for up to 10 years.

Q. Among your top holdings are Allegiance, Keane and Mariner Post-Acute Network. What can you tell us about these businesses?

A. Nothing whatsoever. I don't know what their products are. In fact, I don't even know the names of their CEOs.

Q. Excuse me?

A. A lot of money managers make a big deal out of kicking the tires and meeting company management, but we've got a few problems with that. Company executives don't always tell the truth. They can make you believe their p.r. even when they don't. We see no point in gathering information from unreliable sources.

Q. So you know nothing about these stocks?

A. I didn't say that. I said I don't know anything about their products. Our numerical analysis tells us oodles of things about the value of a stock relative to its peers, as well as what top management is doing with its own money (through insider trades) and the company's money (through share buybacks, etc.). We look at more than a dozen factors that measure value, management and Wall Street's sentiment. We want only the cheapest stocks by these measures--whatever's wounded.

Q. What do you charge to run the fund?

A. Our normal management fee is 0.9%. But we only earn that rate in a year when we beat the Russell 2000 [small-stock index] by three percentage points. If we return more, we earn more [up to 1.5%]; if we return less, we earn less [down to 0.3%]. It's a way to align our interests with the shareholders'. Obviously, if more assets hurt our performance, that will lower our fee. So we won't let the fund get too big.

Q. That makes sense. Why do only 106 of 5,190 U.S. stock funds [according to Lipper Inc.] tie their fees to performance?

A. If those fund managers got paid better only when their performance was good, that would decrease their income.

Q. Do you invest in your own fund?

A. All of my family's retirement money is in the fund. But because the fund trades a lot, it's not suitable for taxable investments. So all of our taxable money is in index funds. I've owned Vanguard Index 500 for 22 years.

Q. You're an active fund manager, and most of your own money is in index funds?

A. Personally, I think indexing wins hands down. After tax, active management just can't win.