Hugging the Benchmark: Games that Fund Managers Play

In response to The Monkey Wins Again, there were some objections to the statement that I suspected Bill Miller to be an index hugger. Well, consider this. For all the value-investing bravado, for all the fancy Mauboussin Strategy pieces (Size Matters PDF), it is very difficult to resist gaming the index.


Yes, Miller makes a conscious effort to keep up with the S&P. Or at least he used to. In Conversation with a Money Master, he explained in great length how they “calibrated” their value investment in Enron:

04-hugger.jpgWhen the stock got down to the mid-teens, we started to do some serious work on it, and we parsed off every hard asset (the pipelines, etc.) against the debt. We looked at all of the off-balance-sheet stuff. It was sort of opaque, but we knew what had gone into it. And we assumed that the equity in the off-balance-sheet partnerships was zero. But we also assumed that it could pay its debt.

We had all of the assets parsed off except for the trading operation, and we valued the trading operation in the twenties — assuming access to capital and assuming an investment-grade rating. So, to make a long story very short, we concluded that if it could maintain access to capital, it was a buy.

So, we bought it starting in the low teens — all the way down to about $3 — and we put $300 million in it. And the reason I’m going on about it is that I think it’s instructive about our process. This was in the fall of 2001 — I guess it was post-September 11.

As we looked at it, we thought there was about a 10 percent chance that it was a zero. We didn’t know of any fraud there, but we knew that, because of all the controversy, if Enron lost access to capital, it would be a zero.

And our view was, ‘‘OK, if it’s a zero, can we still invest in it? How much can we invest in it if it goes to zero and with our overall portfolio, still beat the market?’’ And that’s how we calibrated our position size in it. As it turned out, our average cost was probably $7, and we sold it at 80 cents.

We lost $300 million in 60 days — the fastest that we ever lost that kind of money in our history. But we still beat the market that year, so it wasn’t a total disaster, but it was close.

At this point, the value investments are getting pounded, making it nearly impossible to keep up appearances over at Legg Mason. And all the more reason to remind investors that they are (and have always been) probably better off with a well-constructed ETF portfolio.

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