18

DELIVERANCE

Wellington Management Company Partners
Boston, Massachusetts
September 9, 1971

DELIVERANCE is an extraordinary novel by James Dickey. On the surface, it is an adventure story—telling of four men on a canoe trip in an isolated area, running rapids that are soon to be flooded and forgotten. It tells us something of what it is like not to know what natural dangers or man-made perils, not to know what excitement, may lie at the next turn, not to know how a risky and adventurous trip will end—for four individuals, not all of whom, as it turns out, are equipped to be adventurers. But, much more than this, its theme is the role of danger and stress on the individual, and how deliverance from peril can help us find self-realization and liberation.

The relevance of deliverance to our meeting today goes far beyond the fact that one of the four principals who undertake this canoe trip is a mutual fund salesman. It goes to the fact (I hope I am not overdramatizing this) that in the money management profession all of us—surely I am much as you—are at this very moment rushing down a river whose course is exciting, if not wholly known; navigating a canoe that is solidly seaworthy, if not entirely stable; operating in an environment that has precious little predictability, a certain sense of mystery, and an aura of danger ahead. Our ability to deal with the money management world we live in today will depend, I think, on the skills and abilities and energies each of us bring to this task.

There is so much that has happened, that is happening, and that will happen to our company and our industry that it is hard to know how to cover very much of it, even superficially, in less than an hour. What I propose to do this morning is spend just a brief moment on the past five years and the colossal change wrought in the Wellington Management Company organization, and then look ahead to the future (my charter is to look out to 1976), with special emphasis on the two challenges that I see as having particular importance to our company:

Our ability to deal with these critical questions, of course, will depend importantly on our flexibility—by which I mean a combination of our ability to make decent guesses about the future environment, and our willingness to respond with changes in our organizational structure and strategy. I believe we have demonstrated these qualities in the past. Interestingly, when I looked back five years, I discovered the notes for my remarks to our District Sales Representatives meeting at the announcement of the Wellington/Ivest combination. These comments were made on September 9, 1966, five years ago today. In describing the reasons for this combination (which, as you know, profoundly altered the shape and future of both organizations), I talked about change, using this quotation from a Fortune magazine article entitled: “Tomorrow's Management: A More Adventurous Life in a Free-Form Corporation”:

Looking Back and Then Ahead

In 1966, this was our challenge, which I went on to quantify by specifying a set of five-year financial objectives for our combined organizations. Now that the moment of truth is here, I would like to review four objectives briefly:

• We were to maintain Wellington Fund assets at $2 billion. We failed in this objective. Wellington Fund is now $1.33 billion.
• We were to build our other mutual funds from $150 million to $1 billion. We succeeded in this objective and then some—other fund assets are now $1,190,000,000—a sevenfold increase.
• We were to develop our investment counsel assets from $190 million to $1 billion. We more than met this goal. These assets are now $1,140,000,000—a fivefold increase.
• We were to triple our market share of mutual fund sales from 2% to 6%—and we will meet that objective.

If the score of three to one in favor of good guesses—and that is all they were—is not too bad, I hasten to claim no personal credit. Others too numerous to mention, many of whom I see before me this morning, deserve whatever credit is due. But, change we did. And—miracle of miracles—our change paid off. The five-year period that is ending at this moment is now past, however. It is over. It is done. It is probably of little interest even to the narrowest historian. Its only importance to our organization is in what we have learned—individually and collectively—from the many trials and tribulations, from the hard experience of this five-year period. I will remember, and I soberly urge each one of you to remember, too!

I want to emphasize this morning how important it is to focus on this extraordinary change in our company in the past five years. We have changed Wellington Fund Management Company (while it was not called that, 96% of our revenues were derived from Wellington Fund) to Wellington Management Company—a diversified money management firm which at this point in time, derives 24% of revenues from Wellington Fund, 24% from investment counseling, and 52% from other mutual funds.

Now we must look forward to the next five years, not backward over the past five. I am not going to concern myself with how our assets will be distributed. But, I would guess that if we are to gain the revenue growth we must, we ought to be managing $5 billion in 1976—which I suggest as our goal, even though it is a modest goal, representing only about a 7% growth rate. And, if we are a new company and we are a different company, we are a company with greater resources and, hopefully—if we have learned as we should have from the past five years—greater resourcefulness. We will surely need both greater resources—whether $5 billion is enough or not I am not sure—and greater resourcefulness to deal with the two challenges I spoke of earlier—professional responsibility and fiduciary duty.

The Challenge of Professional Responsibility

Let's turn then to the challenge of professional responsibility. In the years ahead, we will have to meet far more exacting performance standards for our fund and counsel clients. I cannot describe to you the precise nature of these standards. But I can do a little brainstorming, and lay out some broad areas of change based on my conviction that the actual performance of an investment account will be analyzed with increasing intensity. These new standards will incorporate most, if not all, of the following four elements:

1. The total return of an account will be subject to exact measurement. This concept, so familiar to those in the mutual fund industry, will be extended with comparable precision—and by that I assume asset valuation will be generally made on a unit basis no less frequently than monthly—to counsel accounts. Performance measurement will be all-pervasive, and will include the banks, pension funds, individual clients, all types of investment counsel accounts.
2. The concept of risk will come into its own. “Risk-adjustment” to returns will be made with mathematical, though surely not conceptual, precision. In mutual funds, investors will be told about the volatility (is this really risk?) they can expect from a given fund. In the counseling field, investors will be asked about the amount of volatility they can tolerate in keeping with their objectives.
3. The ultimate measurement of performance—in both fields—will be on a units-of-reward-per-unit-of-risk basis. I am not sure which standards will prevail, only that there will be some.
4. With performance standards established, there will also be an increasing scrutiny of the entire investment management process by investors—
   • in the mutual fund field, by statistical services (Lipper Insight, etc.)
   • in the investment counsel field, by large corporate investors.

   In 1976, the world—or at least the investors involved—will want to know whether and what the account was buying when the market was down—and we will have to say what, and why. It will want to know what industry groups were favored, and we will have to answer. Our selection of companies will have to be defended and articulated. Under these circumstances, it is entirely possible that our clients and financial publications may well have more information about what we are doing than we do. (With their computers abuzz, they may detect portfolio trends we are not even aware of, or patterns that emerge without our knowledge.)

The impact of the trends will be profound: To remove much of the mystique from the money management profession—especially the mysterious counseling profession as compared to the mutual fund industry—for two perfectly good reasons: First, the trend toward quantification and rationality I have here reviewed; and second, because the stage for this development has been set in part by the tragic failure of many money managers to provide satisfactory investment accomplishment in the 1969–71 period.

When you consider the impact—magnified by all the accompanying public relations—of Fred Mates, of Fred Carr, of Jerry Tsai, on the investment world, there are few who are not aware of these past shortcomings. As it has been said, we came to realize “that Mates are only mates, a Carr is just a car, a Tsai is but a Tsai”—when we should have realized all along that, as the old song goes, “the fundamental things apply as time goes by.” And if we can't make a song out of John Hartwell or Fred Alger, or Bill O'Neil, or David Meid, we can say each made his own contribution toward taking the mystique out of money management. (While the managers I have mentioned found their inadequacies most evident in the mutual fund field, it is clear that their counseling accounts experienced equally tragic failures.)

I am not blaming these people, none of whom planned to fail. I am merely saying that they helped to set the stage for the 1971–76 era, during which only those firms that can demonstrate consistent standards of excellence in money management will be able to grow and prosper. Only those firms that do an excellent performance job and meet acute investment standards will gain the cash inflow so necessary, not only to provide future growth and resources, but to avoid the drain of steady cash outflow. And within those firms, only those individuals who meet the same tests will enjoy the substantial rewards that accomplishment will bring.

On the evidence—and we should not expect it to be otherwise—few firms have met this standard of excellence in the past. And it is disappointing but true that our own firm, in the last decade, must be counted among those that have not provided consistent excellence. If we are to succeed in the next five years, we must demonstrate consistent excellence in money management. Given our record so far in 1971, we are not starting from a particularly secure base.

In any event, our focus for the next five years must be on meeting standards of excellence, of measuring up to our performance responsibilities. We will have to do so if we are to build our assets. The amount of information on the subject of performance will explode, I am confident, and you can expect and assume that we will have new measurement devices, new evaluation processes, and ever more numbers with even greater complexity. Our 1976 world, then, will be one of greater professionalism, measured in a more rational climate, for all money managers, whatever types of accounts they manage.

I would not predict what adjustments we will have to make to deal with these developments. However, I would assume that new standards will ultimately call for possibly profound changes in our money management procedures, our organizational structure, our compensation programs, and our research activities. Initiative, flexibility, creativity, and adaptability, repeating the Fortune quote, will be critical to our success.

To sum up: Because of the sins and excesses of the past, as well as the communications revolution of the present and future—the quantification and information explosion—the profession of money management will lose much of its mystique. Among the changes that I suspect will emerge would be these:

• First: The big competition for major corporation pension plans may not be other established investment counsel firms, and will not be trust companies. It will be (1) new small investment counsel firms that limit the number of accounts they manage (and thus the regulation they are exposed to), and (2) possibly—even more importantly—the corporations themselves—a trend toward “internalization” of money management. In this context, I would also guess that the trend toward “multiple management” is not too far away from its peak.
• Second: The big competition in the mutual fund field will continue to be within the conventional system of dealer distribution. The dealer, after all, can help the average investor cope with the complex new measurement standards. But major inroads will be made by no-load funds at the expense of captive distribution. The astonishing trend in this direction is little noticed thus far, but is one of the most significant in the mutual fund industry—the no-load funds are now out-selling the captive distribution funds.
• Third: The big competition for equity money management for the average investor may not revolve around one mutual fund marketing system vs. another, but one type of product vs. another. We cannot be sure, for example—despite the Supreme Court decision in the First National City Bank case—that banks are barred from the mutual fund industry; that decision merely bars them from acting as underwriters of, not as investment advisers to, mutual funds. Further, we have no protection, nor are we likely to get any, against other means of marketing equity management in packages that may well prove to have more efficient service, or different cost structures, or more generous sales commissions, or more favorable tax characteristics or regulatory status, than mutual funds. (Here, I refer to the competitive threat of the variable annuity and variable insurance.)

In any event, the competition is not going to get any easier, and performance excellence must be our goal.

The Challenge of Fiduciary Duty

Let me now turn to an equally compelling and critical challenge for money managers in the future—fiduciary duty. We live in a world that is increasingly intolerant, not only of conflicts of interest, but even the appearance of conflicts. It is hard to argue either that this trend is baneful or that it is likely to abate. For this is but one aspect of the “consumerism” whose impact pervades almost every aspect of our society, and certainly is not limited to the world of money management. It seems beyond question that consumerism, along with the entire thrust of the legislative, regulatory, and judicial overview of our profession, will play a critical role in how we conduct our affairs in the years ahead.

What are some of these conflicts in money management that have existed in the past, and how are they likely to be resolved in the future?

• The question of brokerage utilization for various forms of sales and research reciprocity. While I totally disagree with the Appellate Court's reversal of the Fidelity decision in the lower court, and the judgment that the Fund has a right to recapture “give-up” commissions for 1967–68, I have little doubt that the future environment will make any available recapture mandatory. We are in a new world, and even the Supreme Court's unlikely reversal of Fidelity would effect only past practices, not the future. At the same time, the available pool of reciprocal will continue to represent a smaller portion of the money managers’ resources.
• The question of exchange membership. Certainly, the potential for considerable abuse exists in this area, for there is a fundamental conflict between a pure investment judgment where the commission is paid to a disinterested broker and an investment judgment where the manager himself earns the commission. There are, in fact, many managers who depend on generating commissions for their profitability, and (in certain cases) for their survival. It occurs to me that these kinds of pressures are patently wrong. They will ultimately be resolved, not by structural separation, but by the de facto separation that would occur if the negotiated rate level comes down once again.
• The question of asset size and the investment process. Clients—fund directors and investment counseling accounts alike—will not accept massive size unless we can show them that its benefits—and I tried to make the point earlier that substantial resources are important in doing a responsible performance job—outweigh its detriments. I don't think I have to spell out to anyone here what these detriments are.
• Other questions are also in the process of resolution—resolution that must consistently be made in the interest of the client. I would include here the valuation of restricted stock, combined order (bunching) procedures, allocation of orders among different accounts, the apportionment of expenses between fund and adviser, and ultimately the setting of the level of fund advisory fees.

Fund Industry Structure

This last issue—the arm's length setting of advisory fees—is truly a jugular issue. For, if mutual fund independent directors ultimately assume the position of the trustees of an eight- or nine-figure counsel account, one has to raise a question of the very role of a management company—as a separate and distinct entity—in the future. This is a question that has been surprisingly ignored. Listen to Howard Stein of Dreyfus Fund, for example:

Or, is this Howard Stein of Dreyfus Corporation speaking? Or, has he ever considered the applicability of his comments to our own industry situation. (He does not always display consistency in these areas; i.e., opposing institutional access while doing business on the Philadelphia-Baltimore-Washington Exchange and applying for membership on the New York Stock Exchange.)

Indeed, one of the most significant legal decisions affecting our business in over a decade effectually raises this same question. The Lazard case rules in effect—and on a specific set of circumstances—that profits from the sale of a mutual fund management contract belong to the shareholders of a fund, not the sellers of the contract. In the Court's words, “A trustee may not sell or transfer such office for personal gain.… No matter how high-minded a particular fiduciary may be, his duty is to eliminate any possibility of personal gain.” The panel of three eminent jurists appeared to realize that this decision could fly in the face of the court decision in the 1958 ISI case, which enabled management company shareholders to capitalize on the value of the management contract. Some have said the Lazard decision “opened Pandora's box”; my own view is that it is more likely to have closed it. Nevertheless, the Lazard decision raises a profound question: What happens when the common law prohibition against a trustee's profiting from the sale of his office conflicts with the implied right of a businessman to capitalize on the entrepreneurial value of the enterprise he has created? As SEC Chairman Casey recently noted, the Lazard decision is right on fiduciary law, but harsh on businessmen, and may require legislative remedy.

The ultimate answer, I suspect, will be to allow some entrepreneurial profit, but only on terms negotiated at arm's length by a truly independent fund board of directors. It is not inconceivable for such a board to consider steps like these, if they appear important to protect the rights of the fund shareholders:

• In instances of failure to meet adequate performance standards, forced transfer of contract, or contract termination.
• In instances of the proposed merger of a management company, evidence of positive benefits to fund investors, including lower fees, strengthened management, marketing, or administration, etc.
• In any event, more frequent and flexible fee negotiation.

This would seem to say that the ultimate outcome will be neither the “black” of Lazard, nor the “white” of ISI, but rather a true negotiation at which both sides are represented. Certainly, this was one of the original intentions of the Investment Company Act of 1940 (which was aimed, in part, toward prevention of “trafficking” in investment advisory contacts), and more recently, in the Investment Company Act of 1970, which specifically laid down a fiduciary duty with respect to the amount and determination of the advisory fee. If this is correct, it seems clear that excessive management profitability is likely to be under some restraint. There are those who say this is bad, and there are those who say Lazard would eliminate the entrepreneur from the mutual fund business. But, I, for one, am not entirely clear that the entrepreneurs who came into our business in 1967–1969 have served either fund investors, or our industry.

“A Man Cannot Serve Two Masters”

These problems, to be sure, are not new. They merely recur as history is forgotten. Listen, for example, to Justice Harlan Fiske Stone speaking in 1934:

I endorse that view, and at the same time reveal an ancient prejudice of mine: All things considered, absent a demonstration that the enterprise has substantial capital requirements that cannot be otherwise fulfilled, it is undesirable for professional enterprises to have public stockholders. This constraint is as applicable to money managers as it is to doctors, or lawyers, or accountants, or architects. In their cases, as in ours, it is hard to see what unique contribution public investors bring to the enterprise. They do not, as a rule, add capital; they do not add expertise; they do not contribute to the well-being of our clients. Indeed, it is possible to envision circumstances in which the pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Although the field of money management has elements of both, differences between a business and a profession must, finally, be reconciled in favor of the client.

Nevertheless, Wellington Management Company is publicly owned—unlike many of our finest competitors. We have a responsibility to those public investors, who are, in effect, the financial heirs of the entrepreneurs who created this company. They are entitled to a return on their investment, and I would suggest that our management has bent over backward to recognize this responsibility. However, if it is a burden to our fund and counsel clients to be served by a public enterprise, should this burden exist in perpetuity? And if we believe that it is in the interest of our fund and counsel clients that our firm should be owned by its active executives and not by the public, shouldn't we work to solve this problem in a way that is equitable to all? What a great objective to be accomplished by 1976!

Mutualization?

I wish there were a simple way to accomplish what I am talking about, let alone to describe it. But, let me say that a variety of options may open up as the legal atmosphere clears. For example, there may be “mutualization” whereby the funds acquire the management company. (Students of the development of the life insurance business will know how this can come about.) There may be “internalization” whereby the active executives own the management company, with contracts that are negotiated on some type of “cost-plus” basis, providing incentives for both performance and efficiency, but without the ability to capitalize earnings through public sale. (This would be consistent with the changing tax treatment favoring earned income at the expense of capital gains.) And, there may be other variations on these ideas. At the same time, for that matter, we must face the fact that there may be no way to accomplish this goal.

This brainstorming is an important part of what we have to do, for I think a restructured Wellington Management Company may—I repeat the phrase, miracle of miracles—enable us both better to fulfill our performance obligations and more effectively to honor our fiduciary responsibilities. Above all, however, any restructuring must not be at the expense of the organization we have developed. I believe, and I hope you agree, we have created an organization that is worth holding together. Our fund and counseling areas are increasingly interdependent, and not only within the investment management group, but also within the administrative group, which, in turn, interacts with the mutual fund and investment counsel marketing groups.

In candor, I do not know whether maintaining our organizational unity means there will be no change in these various relationships. Legally, for example, cannot funds “mutualize” in a sense that is difficult to conceive of for investment counsel firms? From a regulatory standpoint, is not the fund industry—at least to date—vastly different from investment counsel? Does not fiduciary duty mean one thing when a client can negotiate for himself, and another when he must rely on an independent board of directors? Operationally, is it not conceivable that the funds could be internalized and made self-sustaining with respect to administration and distribution, but continue as at present in their relationship with respect to investment management?

The Challenges Ahead

Questions like these suggest the complexity of the issues that face us as we deal with the next five years and beyond. I hope I have not gone too far in suggesting that the seeds of their resolution may be surprising. But let me emphasize that we will bring to this future the same qualities, toughened by hard experience, that we have tried to bring to past problems. As Howard Johnson, President of MIT—the University, not the restaurateur, and not the mutual fund—warned us at the April Investment Company Institute Membership Meeting, we have to “take a longer view. If we wait until all can see,” he said, “there is no room to act. So many bad decisions are made when there are no longer good choices.”

Speaking personally, the events of the past five years have been an incredibly satisfying experience for me. I hope I am different and better for the challenges we have faced, and for the people with whom I have worked, for both what we have succeeded in doing and where we have failed, for all of the trials and tribulations we have endured. It has been fun, and I only hope that each of you has experienced at least some of this range of sensations—for that, not to be too melodramatic, is what life is all about.

In Wellington Management Company, we—with the emphasis on we, for I is neither critical nor important—have built something that is quite precious. A young organization. An open environment. A professional orientation. A responsive and alert group of people who have great ability, people who (to quote Schow's Law, which is said to govern hiring at Capital Research and Management Company) “it is at least possible to like.” Our future is no more uncertain than the future of anything else, and I see no reason you cannot earn a generous enrichment here—personal, professional, and financial—in an organization that must remain both independent and unified, irrespective of whatever structural change may evolve.

Lest there be any possibility of misunderstanding, let me put my conclusions in a more simplified form:

In 1976, then we may well be a different company than we are now, but one that is better rather than worse. I repeat what I said earlier: initiative, flexibility, creativity and adaptability are the attributes that are required, as we go about the task of providing consistent excellence in investment management, under increasingly stringent standards of fiduciary duty. If we do so, our ride down the river I described to you at the outset today will be exciting. We will enjoy the sense of adventure in a financial world where it is all too often lacking. And, we can achieve, hopefully, a “deliverance,” not in the narrow sense of a safe arrival at a final destination—surely we wouldn't want that even if we could have it—but in the broader sense of liberation, an enhancement of our very selves.

Or maybe Deliverance is just another adventure story.