Where are the portfolio managers' yachts?

High-performing portfolio managers are worth their weight in total return. But many remain unappreciated by top management

In his 1930s book, Where are the Customers' Yachts.e, former broker Fred Schwed gave the inside scoop on the Wall Street of his day. Tile title refers to an old

In this column we often address securities that are poor rewards for the risks entailed. These are bonds designed to provide yachts for the issuer or broker, but not for the investor.

This makes us wonder, what about the portfolio managers who make all the best risk-reward decisions? Do they in fact contribute significantly to the bank's bottom line? If so, where are those officers' yachts? And, if it is possible to obtain higher returns by investing more knowledgeably, should there be performance-based compensation for portfolio managers?

Returns, not yield

Before performance can be rewarded, we must decide what constitutes good performance. One of the most common measures of performance is to compare portfolio yield versus peers' yield. This might make sense over longer periods of time. However, over the short term such a measure can lead to intentional, and more commonly, unintentional excess risk taking in order to prop up the income statement. As regular readers will know, we believe yield is generally a faulty measure and prefer total return.

An extreme example demonstrates the principle. Consider Bank A, which purchases a 7-year callable 3 agency security in 1990 at an 8.83% yield. On the same day, Bank B buys a noncallable agency that offers less yield--8.53%, to be exact. For three years, Bank A out-incomes Bank B. But in 1993--you guessed it--Bank A's bond gets called away, and is replaced with a new 4-year agency yielding 4.92%.

The first poor decision here was selling a call option for 30 basis points. For three years this tack dressed up Bank A's portfolio income versus Bank B, but for the last four years, Bank A will receive 4.92%, while Bank B is still earning an 8.53% coupon. That represents a spread of 361 basis points. Over the life of these two strategies (7 years), Bank B will outperform Bank A by more than $150,000 per $1 million invested.