Henry Mintzberg On Executive Bonuses

It's rare that I read a Wall Street Journal article that is almost completely wrong-headed, but recently, I found one. It was in the November 30th edition's special section, entitled "No More Executive Bonuses!" by Henry Mintzberg. Mr. Mintzberg is a professor at McGill University in Montreal, Canada.

Here's how Mintzberg begins his half-page-plus rant,

"These days, it seems, there is no shortage of recommendations for fixing the way bonuses are paid to executives at big public companies.

Well, I have my own recommendation: Scrap the whole thing. Don't pay any bonuses. Nothing.

This may sound extreme. But when you look at the way the compensation game is played—and the assumptions that are made by those who want to reform it—you can come to no other conclusion. The system simply can't be fixed. Executive bonuses—especially in the form of stock and option grants—represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy. Get rid of them and we will all be better off for it."

I have a lot of problems with large cash or even equity bonuses awarded for short term performances and, if equity, vesting for sale in only a year or two. But I'd hardly go so far as to eliminate bonuses entirely. And Mintzberg never provides evidence for his claim. None. There's no empirical evidence anywhere in his screed.

His next interesting passage reads,

"First, they play with other people's money—the stockholders', not to mention the livelihoods of their employees and the sustainability of their institutions.

Second, they collect not when they win so much as when it appears that they are winning—because their company's stock price has gone up and their bonuses have kicked in. In such a game, you make sure to have your best cards on the table, while you keep the rest hidden in your hand.

Third, they also collect when they lose—it's called a "golden parachute." Some gamblers.

Fourth, some even collect just for drawing cards—for example, receiving a special bonus when they have signed a merger, before anyone can know if it will work out. Most mergers don't.

And fifth, on top of all this, there are chief executives who collect merely for not leaving the table. This little trick is called a "retention bonus"—being paid for staying in the game."

Mintzberg does a tricky thing here, which is to mix performance bonuses with other types of special payments, such as for exits, mergers, or merely staying. I am with him on eliminating these types of bonuses. But, frankly, that's not what I believe is the major concern of most observers. And retention bonuses are really a non-performance version of performance bonuses, i.e., they are normal annual occurrences.

As for the performance bonuses, the first comment is irrelevant. I honestly don't know what it means for bonuses. But on the second point, I have argued since 1997, in an article I wrote for Russ Reynolds' Directorship Magazine, that the appropriate manner of paying executive bonuses is for them to include the following:

1. Cover a five year period.
2. Be measured as total return.
3. Performance for the period must be above the S&P500 total return.
4. If performance is for a year, then the bonus is to be paid in equity which can't be sold for five more years.
5. If performance is measured for the trailing five years, it may be paid in cash.

By these guidelines, a CEO can't pump the company's performance for just a year or two, collect cash or sell the bonus stock shares, and watch as shareholders experience subsequent negative absolute or, relative to the S&P, total returns as the after effects of his actions become clear.

Mintzberg then lists what he believes are "faulty assumptions" surrounding performance measurement and bonuses,

"But I believe that all these efforts are doomed to fail as well. That's because the system, and any proposals to fix it, must inevitably rest on several faulty assumptions. Specifically:

• A company's health is represented by its financial measures alone—even better, by just the price of its stock.

Come on. Companies are a lot more complicated than that. Their health is significantly represented by what accountants call goodwill, which in its basic sense means a company's intrinsic value beyond its tangible assets: the quality of its brands, its overall reputation in the marketplace, the depth of its culture, the commitment of its people, and so on.

But how to measure such things? Accountants have always had trouble when they have tried, as have stock-market analysts, investors and even potential purchasers of the company. (That's one of the reasons so many mergers fail.) No board of directors is going to have much luck finding that elusive measure, either."

This is just silly. We know that the market value of equity represents the value of a share of a company, as determined by both those wishing to buy or sell the equity. Mintzberg obsesses about book value and accounting issues, but simply ignores the fact that market values just is the current value, in consideration of expectations of future value. And it does, indeed, represent intangibles, in an accounting sense, but valued in dollar terms by the market.

"• Performance measures, whether short or long term, represent the true strength of the company.
For years, the idea was that a company's short-term performance represented its long-term health. The banks and insurance companies have pretty much laid that assumption to rest.

So now there is focus on trying to link bonuses with longer-term measures. Well, I defy anyone to pinpoint and measure such performance in any serious way and attribute it to one or a few executives.

How do you assess the long-term performance of a chief executive? Some proposals look at three years, others as many as 10 years. But can we even be sure of 10 years? Is a decade long enough in the life of a large company, with all its natural momentum? How many years of questionable management did it take to bring General Motors to its knees?"

Again, Mintzberg misses the larger point. CEOs are responsible, accountable and have the authority for resource allocation and performance of the firms they lead. Different boards may choose different timeframes, depending upon their products and markets, over which to measure performance and grant bonuses. But just because Mintzberg can't conclude there is one best timeframe doesn't mean each board can't arrive at a suitable one for their situation.

The best may be the enemy of the good in Mintzberg's eyes, but it need not be for board members.

"• The CEO, with a few other senior executives, is primarily responsible for the company's performance.

What if the CEO was lucky enough to have been in the right place at the right time? When it comes to a company's current performance, history matters, culture matters, markets matter, even weather can matter. How many chief executives have succeeded simply by maneuvering themselves into favorable situations and then hanging on while taking credit for all the success? In something as complex as the contemporary large corporation, how can success over three or even 10 years possibly be attributed to a single individual? Where is teamwork and all that talk about people being "our most important asset?"

More important, should any company even try to attribute success to one person? A robust enterprise is not a collection of "human resources"; it's a community of human beings. All kinds of people are responsible for its performance. Focusing on a few—indeed, only one, who may have parachuted into the most senior post from the outside—just discourages everyone else in the company. "

Nobody said a company can't give bonuses to each worker. Some smaller firms do precisely that. It is argued by those CEOs that it's only fair that every worker be similarly motivated along with senior executives.

So, again, Mintzberg sets up a straw man argument, but overlooks an obviously better, actually workable one.

On that topic, later, he writes,

"One alternative, of course, is to pay bonuses to everyone, perhaps according to their base pay. That solves one problem but not another: how to ensure that the goodwill is not being cashed in by everyone, collectively. Once again, who is to come up with the measures that assess performance correctly?

So, again, there is but one solution: Eliminate bonuses. Period. Pay people, including the CEO, fairly. As an executive, if you want a bonus, buy the stock, like everyone else. Bet on your company for real, personally."

Again, there is a solution- set an appropriately lengthy timeframe over which performance is measured. It's really very simple. Also, the board can adjust these measures as they observe how the performance bonus calculations are working.

He does, however, mention one thing which is hardly new, but is sensible. It's the only paragraph in the entire editorial with which I agree.

"People pursue the job of chief executive for all kinds of reasons: the prestige of the position, the sheer pleasure of heading up a major company, the chance to make a real difference to an institution they cherish, and, of course, remuneration. When push comes to shove, do you think pay is more consequential to these people than the other factors? All this compensation madness is not about markets or talents or incentives, but rather about insiders hijacking established institutions for their personal benefit."

It's no secret that boards are often composed of CEOs of other companies. Thus, when a board hires a compensation consultant, and that consultant recommends all manner of higher compensation to "attract" CEO talent, these higher levels of CEO compensation bleed into the other companies over time. Voting for higher pay for a CEO by a sitting board member who is also CEO of another firm is almost like voting her/himself a similarly higher compensation level.

This is one area in which all shareholders are injured by the nature of boards. The fact is that most CEOs would gladly take their job at 2/3 or 1/2 the total compensation they now receive. They just don't talk about it publicly.

On a related note, yesterday, on CNBC, I heard a debate considering some recent speech on senior executive compensation, bonuses, and greedy behavior allegedly given by inept, underperforming GE CEO Jeff Immelt.

One of the program's guests accurately fired off a remark to the effect that Immelt has already hauled down enough from GE's overly generous board (see my posts labeled "Immelt") to be able to speak sanctimoniously. And he hasn't offered to give back the overcompensation for actually reducing his shareholders' wealth.

For the record, I believe CEOs should be paid no more than about $350,000 in cash. Period. No special bonuses in cash.

Then, their incentive compensation should follow some variant of my recommendations in the early part of this post. That is, equity in some percentage of the difference between their 5-year average total return for shareholders and that of the S&P for the same period. If the measurement period is annually, then the equity should only vest after five years. If the measurement period is five years, then the bonus may be ex post, in cash.

The important elements are a smaller absolute cash amount than is typically paid now, and an incentive bonus which is tied to multi-year performance, measured by total return, in excess of what a shareholder could have received from merely holding the S&P. The difference might even be increased to adjust for the risk of holding the company's equity in isolation.

On GM, Ed Whitacre & Old Telephony

I recently had the occasion to speak with two former colleagues from my days at ATT some 25 years ago. One was a recent reconnection after a lapse of nearly all those years, while the other was the most recent in a continuing series of lunch meetings.

To provide some context, I left ATT when it was at the height of internal confusion over the divestiture of the operating companies. By 1983, the Reagan Justice Department had accepted the Modified Final Judgement of what was formally known as Computer Inquiry II.

Computer Inquiry I, dating from around 1956, resulted in the Bell System, via its Western Electric unit, being prohibited from entering the data processing business.

The second inquiry, known internally as CI II, involved the determination of the terms under which ATT would be allowed to sell, rather than simply continue leasing, customer premises equipment, known in shorthand as CPE. Practically speaking, this referred to on-premises telephone switching equipment, handsets, modems, etc.

This became important to ATT because, by the late 1970s, vendors such as Rolm and Mitel were causing serious damage by selling CPE, which could be financially preferable for customers to perpetual leases from ATT.

In the event, the Justice Department requested ATT to spin off Western Electric, in order to prevent market foreclosure. It was thought that, since ATT owned nearly all of the single, regulated monopoly telephone network in the US, allowing it to own Western would give it unfair price advantages over other vendors. There would be non-price and price discrimination in favor of Western. Certainly, there had been the former for a very long time.

To make this a shorter post, I'll simply provide some highlights, based upon facts and supplemented my own knowledge, and that of my colleagues, both then, and since.

Rather than accept the DOJ's request, ATT's then-chairman, Charlie Brown, under heavy influence from the Long Lines senior management, chose instead to offer to divest the entire group of 28 operating telephone companies.

Brown and every one of his predecessors had risen from the operating companies. Long Lines, the Bell System unit which provided inter-company long distance lines and services, had never run the entire company. Because of regulatory accounting and various internal tariffs and subsidies, long distance appeared to make a considerable portion of the profits of the regulated ATT. Thus, Long Lines executives were frustrated, and saw CI II as an opportunity to exact some revenge.

As it was explained to me as early as the mid-1980s, Long Lines executives saw the operating companies as hopelessly outdated distribution outlets saddled with twisted pair copper wire connections to each household, capable of a meagre 64KPS of capacity. They lusted after a broadband connection, but knew that replacing all the copper would be financially untenable. And an omnipotent ATT would never be allowed to buy cable companies.

But an ATT shorn of the Telcos might.

The story was, according to several sources, that Brown was heavily influenced to reject DOJ's request, and offer the entire operating company network, instead, in order to gain access to the burgeoning world of data communications traffic and devices. Thus, CI I would be effectively mooted. The Long Lines executives cleverly maneuvered the head of the relatively new Business Marketing units, a former IBM VP, Archie McGill, to pressure Brown from another angle, arguing for relief from CI I, to sell data processing and communications equipment.

The resulting deal Brown struck with Washington had more unintended and unforeseen consequences than anyone ever imagined.

Shortly after the divestiture, I was told, Brown was given an analytic presentation by one of the then most-respected US management consulting firms. Essentially, he was told, he had exchanged a slow-growing business, voice communications, in which ATT had immense share and strength, for access to a much faster-growing (15% pa) data-oriented business in which ATT had almost no presence, and for which its management was totally unfit and unprepared.

The apocryphal story had it that Brown cancelled the rest of his agenda for the day and went golfing to try to digest the shocking news he'd been handed. Sadly, the analysis reportedly given Brown that day proved to be only too accurate.

As things evolved, what had been Western Electric, rechristened Lucent, was, in fact, spun off by 1996. It took a few years, but eventually, ATT learned a rather obvious lesson. Western's primary customers had always been the operating companies.

Guess who no longer liked the idea of buying from a company now contributing to the financial strength of their largest competitor, ATT? Yes, the operating companies.

Since the operating companies had been more managerial fiefdoms than true economically-justified entities, they rapidly re-constituted into a very few regional ATT look-alikes. In time, after numerous mergers, only two emerged- Verizon and Southwestern Bell. Both had, as rapidly as possible, focused on cellular communications and broadband services, putting them into direct competition with their old owner, ATT.

In all of this, however, there loomed large a business and financial fact. Old-style circuit-switched telephony depended upon regulatory tariffs. These were set, as with most utilities, like power companies, based upon assets.

In effect, those portions of your telephone service which were subject to regulation were priced to provide the telephone company a target rate of return on assets. That's why the old Western Electric built gold-plated, everlasting switchgear. That's why the telephone companies capitalized unbelievably large amounts of labor to install said switchgear as asset value.

In 1983, the average line management talent of ATT was basically involved in internal allocation fights, regulatory affairs management, and some small but ineffective amount of competitive activity. The truth was that what ATT and its units did was take a regulatory-provided pot of money and divide it up, using somewhat initially arbitrary, but thereafter consistent rules, among the various operating companies, Long Lines and Western Electric. From that pot of gold, funding for Bell Laboratories was also provided.

My point in relating this history is to provide some background for the world of then-middle and -senior ATT and operating company management. Folks like, well, Ed Whitacre. And some of my former colleagues who hung in at ATT and gradually moved up the ranks amidst the ongoing confusion as the newly-deregulated firm went through amazing changes.

Changes like the huge purchase of McCaw Cellular by Bob Allen, then CEO of ATT. Unfortunately for Bob, they bought high, only to, much later, spin off the unit for a smaller market value.

Then there was the spin off of Lucent, and its subsequent troubles, as it lost captive markets and came face to face with its high cost structures in the face of lethal price competition from European telecoms vendors such as Ericsson.

ATT also tried to create a credit card, the ATT Universal Card. That, too, went nowhere. I had actually interviewed with Allen's strategy executive around the time that the company was busy launching the product. When, with my financial services background, Dick Bodman suggested that I let him send me over to that unit, I politely declined. Having been heavily involved in Chase Manhattan's own credit card business on several occasions, I didn't see ATT as either really understanding the business, nor being able to benefit from it in the long term. Within a year, ATT sold the operation to Citibank.

The final straw came when, after Allen's ouster, Hughes Electronics' CEO Michael Armstrong was recruited at CEO. He immediately set about re-establishing ATT's end-to-end connectivity via a combination of broadband cable and fixed wireless. He bought TCI from John Malone and then looked to Bell Labs for a promised "last mile" solution which would eschew copper wire and opt for a wireless solution.

Suffice to say, Armstrong misunderstood the difference between operations standards for a voice network and the existing cable systems for which he put ATT into heavy debt.

In time, the strategy failed to produce in time and/or at cost to avoid looming debt payments. Armstrong was forced to break the company up. Like Lewis Carroll's famed Cheshire Cat, soon only the ATT name remained, and even that became the property of Southwestern Bell, which bought what remained of the "old" communications firm once known as ATT.

What struck me as I lunched with my old friend earlier this week was one now-glaring fact. The many well-compensated executives who remained with ATT for significant portions of the years after 1983 effectively destroyed their company. For that matter, most of the operating company executives have done little better. There doesn't seem to be a stampede from other businesses or consultancies to recruit senior managers from any of the old ATT components to contribute in other business environments.

The nearby price chart for the remaining Bell System components, sans Lucent and its spinoffs, and the S&P500 Index, displays how dismally the old telephone companies have performed. It's difficult to interpret ATT, since it is likely SBC, the surviving entity. Thus, the true size of the failure of the 'new' ATT is easily displayed. But both of these "survivors" have underperformed the index since the tickers can be tracked back to the early 1983 divestiture.

The only true core competence remaining with the "new" ATT of 1983 was long distance, and that business proved all too vulnerable to MCI's and Sprint's price competition. ATT proved less than adept at sustaining profitable consumer or business telephone products businesses, and it was forced to buy someone else's cellular business, despite having originated the concept in its then-owned Bell Labs.

I marveled at how some of my former colleagues had chosen to stay at ATT, and inevitably climbed upwards in a shrinking pond by dealing with mostly internal issues. Customer satisfaction had never been a major part of ATT's management ethic, and that didn't seem to change after the divestiture.

For that matter, it wasn't really a high point with Verizon or SBC, either.

You seldom hear of a former Bell Operating Company or ATT senior executive succeeding elsewhere. Aside from being steeped in the ways of old-fashioned circuit-switched voice communications technology or internal fighting over tariff-provided revenue streams, they didn't prove to be especially good at managing in truly competitive environments.

Thus my dismay at Ed Whitacre's choice to head GM. If anyone has little practical experience meeting customer needs, it would be a former regional telephone operating company senior executive. The bulk of the efforts of those companies' CEOs for over a decade had been merging with one another to restore the once-realized, then eliminated, through divestiture, genuine economies of operating a nationwide circuit-switched telephone network.

As I reflect on the crazy outcomes of the now over 25 years' old breakup of the old Bell System, nothing in the ensuing activities of any of those who remained engaged in those businesses would seem to have the slightest relevance to resurrecting a failed designer, producer and marketer of big ticket consumer goods.

More Predictions of State-Budgets Based Economic Recession

Meredith Whitney was on CNBC earlier this week discussing more than her usual bailiwick of consumer credit. Instead, she dwelt on the coming budget crisis for US state and local governments.

In this recent post, I described how David Rosenberg also saw this issue as one which few people understand, but will be a key factor in US economic weakness next year.

Now it is clear that both forecasting this event.


A few days ago, Moody's put Illinois on a credit downgrade. According to CNBC's Rick Santelli, Illinois is now the worst-rated state after California.

Amidst all the attention paid to federal spending, the unemployment rate, and equity markets, the perilous economic condition of several large US states and many local governments has been overlooked by many pundits.

Meredith Whitney predicted that the effects of these problems will hit home next spring, when tax receipts come due, and fail to provide expected revenues for these many struggling governmental entities.

The Folly of TARP & Government-Mandated Capital Raising

I had to laugh when I read yesterday's Wall Street Journal article concerning the federal government punishing Citigroup and Wells Fargo with heavy capital requirements before they can repay the TARP money they were forced to take.

If anything points to the veracity of Anna Schwartz' comments about the financial sector crisis of last year, this episode would be it.

Why are we letting some middle-level bureaucrats dictate what sort of capital levels these two banks require, when the obvious, better solution is to let the capital markets signal that. Under-capitalized banks will see their equity prices fall. If they are in a jam, where dilution to raise capital further depresses equity values, then, eventually, some other bank management will take over those assets at the depressed price.

That's how the market votes on managerial (in)competence.

Government mandates for capital are just stupid. Just as the Fed can set a funds rate, but can't actually control market appetites for Treasuries, or force banks to lend, arbitrary capital requirements set by mediocre regulators won't actually have much meaning to investors.

This latest dustup over banks trying to repay government funds shows clearly what a travesty Hank Paulson's and Ben Bernanke's TARP plan always was.

Now, as of this morning, Treasury Secretary Geithner sent a letter to Congress notifying it that he will extend the TARP slush funds and dubious authority until next October.

To add comedy to this act of governmental overreach, Geithner claimed both that the financial sector is still in need of help, but, magically, the government assistance will now actually aid "main street."

Good luck with that, Tim. It hasn't worked yet.

The True Cost of GE's Ownership of NBC/Universal

An article headline in Friday's Wall Street Journal reveals the hidden, true cost of both former CEO Jack Welch's and his successor, Jeff Immelt's insistence that GE's entertainment unit, NBC/Universal. It read, "GE to Invest in Industrial Businesses," with the sub-headline, "Cash From NBC Deal Will Help Burnish Aviation, Health-Care and Energy Units."

It doesn't take a genius to figure out that if GE plans to use the proceeds of its media unit sale to invest in its industrial units, then they must have been starved of said investment for years. This is the hidden, true cost of unnecessary conglomeration in today's financial environment of inexpensive trading expenses and relatively easy access of companies to capital.

Granted, this year and late last year have seen credit tightening for small and marginal businesses. But, compared with the era in which Jack Welch took over GE, diversified conglomerates can now only be defended on the basis of being, in reality, closed-end investment companies.

If Immelt has decided that GE's industrial units required more capital than they have been allocated for years, doesn't this argue that they would have been better-managed as standalone units which could have simply gone to the financial markets for necessary, additional capital?

Here are two statements that can't be simultaneously true:

1. GE's corporate structure and existence benefit its component business units.
2. GE's ownership of NBC/Universal prevented necessary capital from being allocated to its industrial units.

We know, by Immelt's admission last week, that he believes the second statement to be true. Therefore, the first statement can't be true.

Of course, that first statement is Immelt's constant refrain for why GE exists and, by extension, his job does, too.

Nobody seems to be asking the hard, obvious question of the inept CEO of the ailing conglomerate, i.e.,

"Why does GE exist if, under its and your management, the company has starved all of its industrial units of needed capital while owning the financial services and entertainment units?"

Surely shareholders would have been far better off owning their individually-desired mix of equity in various GE units, as standalone entities, then they have been holding a single GE equity.

As I mentioned in this post, referring to the comments of a recent guest on CNBC,

"One of this morning's guests noted that GE ran with way too much short term debt and got caught last year in a refunding squeeze.

From that crisis, he asserted, came the idea to lighten the conglomerate's debt load by jettisoning the media unit. He then lamented that they did it at a time of such a low price for the unit. Finally, he noted, perhaps this would help remove "the conglomerate discount" in GE's price."

The "conglomerate discount" is why GE shareholders would be better off being allowed to choose which business units to hold as separate entities.

Any way you view it, Immelt has continued Welch's mistake of funding the entertainment units while unintentionally starving the industrial units of apparently needed investment, then suddenly changing his mind about the importance of NBC/U to GE, and dumping it at a low value.

Where's the outrage for this incompetent management by GE's CEO?

What GM Needs

My old friend and one-time squash partner Paul Ingrassia, formerly a senior executive of Dow Jones and the Wall Street Journal, wrote a very clearly-reasoned piece in Thursday's Wall Street Journal arguing for a "culture war" within GM.

Paul knows the cultures of the US auto makers well, having covered them for years as the Journal's Detroit bureau chief, and writing a Pulitzer prize-winning book about their comeback from near-ruin over a decade ago.

In this case, though, I respectfully disagree with Paul's conclusions. To me, it no longer matters what happens to GM, because it's no longer a viable private enterprise. Instead, like some captured human in the movie Alien, it's being kept alive to feed union employment and pension funds. But it no longer has a real life on its own.

Joseph Schumpeter's theory of "creative destruction" had in mind precisely companies like GM. Badly managed for decades, its equity price prior to the government takeover having fallen below that of the late 1950s, it was the sort of firm that had to be allowed to fail. If not, its inept management would be propped up, given more societal resources to waste, and, by simple mathematics, reduce the productivity of the nation by throwing valuable economic resources down a money-losing drain.

Were there parts of GM which could have made money on their own? Quite probably. And putting GM through orderly Chapter 11 bankruptcy would have allowed such business units to be either spun out individually, or bought by consenting bidders.

Paul is right, the old GM culture was flawed and needs to be extinguished. How better than to have put the old GM to death, allowing the valuable pieces to begin anew without the suffocating, clueless old managerial culture?

As I've contended in prior posts, simply cutting checks to each displaced blue-collar union worker would have cost less than shoveling billions into GM and GMAC. Assisting temporarily idled employees is a much different matter than subsidizing bad management in a shrinking, commoditized product sector.

It seems that nobody takes seriously the very real costs to our nation of ignoring Schumpeter's concepts. Economics is about allocating scarce resources to the best uses. When government intervenes to allocate taxpayers' money on political grounds, to failing firms, it is deliberately damaging economic productivity, rewarding failure and starving other, more deserving business projects of financing.

The truth is, virtually any more resources, including government expenses for administering and overseeing the walking-dead GM, devoted to this company are just a waste of capital.

GM doesn't really need a culture war. It needs to finally be put to corporate death.

Fama & French Again On Active Investment Management

Last Thursday's Wall Street Journal featured an article reviewing a recent study by Eugene Fama and Ken French reprising their original work from the 1960s. In their update, they once again hold that active managers, as a group, do not outperform the equity markets.

The article states,

"The fact that some funds in the professors' study beat the simulations does suggest that by picking the right funds investors can consistently outperform the market. But there's just one problem, according to the professors: The "good funds are indistinguishable from the lucky bad funds that land in the top percentiles." "

Fair enough. Many of us have known for years of the parlor trick of beginning a game with, say, 64 investment advice letters predicting only an up or down market. If, in six sequential rounds, half are removed as wrong, and half go to the next round, a randomly selected investing approach appears to have had six straight years of skillful outperformance.

An apocryphal story has been around for years that Fidelity Investments actually selects its funds in this manner.

In any case, it's true that some investing ideas are luckier than smart, especially in monotonically favorable equity markets.

Mr. Mamudi's piece continues,

"That leaves picking the right fund a matter of guesswork. So even if investors stick with the top performers, they're running a risk because the manager's good results could be based on luck."

From my days in hedge fund management, I can add another risk. Back then, a friend would send me his copy of Cambridge Associates' published results of investment managers. What struck me was that roughly a quarter of public equity fund managers would beat the S&P in a given year, but it was a varying group.

Thus, an investor was faced with the difficult challenge of choosing an outperforming manager, in advance, from a constantly changing group each year. The number of managers who could outperform the S&P over more than four years were very few.

However, this isn't all that surprising. Equity investment management is a sort of cottage industry. Thousands of people are public fund managers, and, with so many, there are bound to be a lot of inept practitioners.

One might be better off beginning to sort public equity fund managers into groups simply by whether they'd outperformed the S&P by, say, less than 2 consecutive years, 3-5 consecutive years, and 5+ consecutive years.

I've been involved with equity investment management for over a decade. In that time, I've noted that it's far easier for a well-connected manager with mediocre results, or no track record whatsoever, to attract sizable investor funds than it is for a lesser-known or well-connected manager with a demonstrably better performance record. It is, I think, very much like the old conundrum of 1960s IT managers faced when choosing between IBM or another vendor.

The old saying went, 'nobody was ever fired for choosing IBM.'

And so it apparently goes with a large swath of investment managers. When a Vikram Pandit leaves Morgan Stanley and starts up what turned out to be an under-performing hedge fund, he attracted a large amount of investment capital. We constantly read about sticky investments in well-known but now lackluster public funds.

As Fama and French allow in their research conclusions, there are some consistently superior, skilled managers. But finding them is problematic because of some similar-looking performance records for brief periods of time by other managers who are, literally, luckier than smart.

Perhaps an apt perspective was provided by a one-time colleague and principal in a hedge fund with me. The colleague, an ex-Salomon partner, mused, to paraphrase him,

'Pity the average retail investor. The best options he has is a choice among actively managed mutual funds which, on average, can't even beat the index.'

Like so much of the finance sector, investment management, too, has seen a flight to private management of the best talent. Hedge funds have been, for at least two decades, the province of better managers who shun the added regulatory headaches and limelight of publicly-offered investment funds.