I have heard the story attributed to Milton Friedman and a vacation in China, and I also have heard it attributed to a nameless economist doing mission work for his church. Personally I doubt it ever occurred, but as with many legends and myths, the fact it didn’t really happen does not make it any less true.

It goes like this: An economist travels to a far-off land to help the native people build a dam to provide power and a source of clean water for their village. Before leaving for his trip, he gathers donations to pay for the heavy equipment they will need to build a modern dam in this remote area. Upon arriving he notices that the heavy equipment has arrived safely. He also notices that the natives have already begun work; however, they are not using the modern machinery. What he sees looks like a scene out of movie about the building of the pyramids of Egypt – he witnesses a mass of humanity battling the force of a river with nothing but shovels. It looks awful to the modern eye.

Our economist hero immediately demands to see who is in charge. The foreman comes forward – our hero half expected him to be carrying a whip – and greets the new visitor with enthusiasm. “We are glad you are here, thank you for your financial support and the help you are giving us,” he says. “No problem, glad to do it,” the economist responds, “but I have to ask. What is going on here? Why isn’t the equipment we paid for being used?”

“If we use this heavy equipment we would eliminate many of these jobs and we simply cannot do that,” explained the foreman.

“Oh,” responded the economist. “I think there has been a misunderstanding. My organization was under the impression you were trying to build a dam. But you are trying to create jobs. If that is the case, you should take away the shovels and give the workers spoons.”

The moral to the story is that it is important to distinguish from a symptom of a problem versus the problem itself. If the leaders of this mythical community really wanted to create jobs they should focus instead on economic growth. The faster they finished the dam, the faster they could generate energy and better control the water supply, which could bring industry and/or agriculture to their community, which would create much better jobs than shoveling mud. These jobs would also last beyond the length of the dambuilding project, and the jobs themselves may create needs for other jobs in services such as childcare; they may even need a local bank…oh no, there goes my make-believe town, now it will be destroyed by the ‘evil banker.’

Those future jobs are hard to see in the present moment. It all makes sense in my mythical village, as it does when we look back in history. In 1800 America was a nation of farmers, with roughly three-quarters of the labor force working in agriculture. By the eve of the Civil War, only half worked in agriculture; by 1900, one-third; and today, less than three percent of our labor force is in agriculture. This does not mean that food production has gone away – U.S. agriculture has maintained a positive trade surplus for decades, producing more food than even our overweight society can consume.

The industrial economy has seen the same phenomenon over the last 60 years. There is a firmly held belief that America has lost its manufacturing edge to competitors overseas, mainly to China. Like most conventional wisdoms, this belief is not true. In 1947, a little less than 15% of the total gross domestic product (GDP) came from manufacturing. Today that percentage is roughly the same and it has been stable throughout that 60-year period, meaning American manufacturing has grown in line with the economy as a whole. However, in 1947 manufacturing represented over a third of total employment in the U.S. There were lots of relatively low-skill, high-paying union jobs. Today that is no longer the case. Manufacturing represents less than a tenth of our total workforce, but the vast majority of those jobs were lost not to competitors but to technological advances. This is important to understand because jobs lost to competitors could be won back, while jobs made obsolete by technology are gone forever.

This reality is hard to hear and it is painful to go through, but this is a necessary process which the famous economist Joseph Schumpeter called ‘creative destruction’ – the old must be destroyed so the new can take its place. American history is full of these episodes and we owe much of our global success to the fact that, for the most part, throughout our history we have allowed this economic cycle of innovation, boom, decline, destruction and new innovation to keep on cycling. Most notably, in the last 100 years we faced two times when unemployment reached the levels we are near today. The reaction to those two periods could not have been any different and the lessons learned are important for us.

The first such period was the Great Depression. In 1933, the unemployment rate hit 24.9%, and the government reacted by passing a slew of new regulations on industry, increasing spending, and creating new entitlement programs and ‘make-work’ jobs programs. All of this was very popular as it made the government look like they were ’doing something.’ Yet in 1939, the unemployment rate was still 17.2%. Things got better, but not by much.

The second time the unemployment rate got up to near double digits was in 1982. At the end of 1982 the unemployment rate was 9.7%, and the government reacted by reducing regulation, reducing the size of government, and lowering taxes. The public response at first was not positive, since it appeared that government ‘didn’t care.’ By 1989 unemployment was down to 5.3%. Government continued to downsize through the 1990s and in 1999 unemployment stood at 4.2%.

One approach didn’t work and the other did. But, there were some side effects to the second approach. Most notably, there has been a disturbingly increasing gap between the haves and the have-nots.

Today we sit between a rock and a hard place. To produce jobs, we must encourage innovation by providing economic freedom, but we must also do something about the growing bifurcation of our society. This dilemma is spelled out very well in Jim Manzi’s essay for National Affairs, “Keeping America’s Edge.” Unfortunately what Manzi describes – correctly, in my opinion – as a “dysfunctional political dynamic” is preventing us from actually facing this challenge and has instead “given us the worst of both worlds: a ballooning welfare state that threatens future growth, along with growing socioeconomic disparities.”

Liberals are correct when they point out the disparity of the rich versus the poor in our country today, but they are blind to the reality that their attempts to control economic activity centrally are counterproductive and actually make things worse. Conservatives are correct when they argue for the power of the free market, but they are blind to increasing inequality. We live in a world where increasingly people are able to avoid any bit of information that does not fit with their world view. They increase their closed-mindedness by digesting only views with which they know they will agree. This serves only to grow our respective blind spots and our political dysfunction.

There are solutions, and I will discuss some during the course of this year. But they are going to require a mature facing of facts – all the facts. Big government does not work. We need to do something about the economic disparity in our society – starting with reforming education. We need a state-of-the-art regulatory system to govern the financial markets. If we do these things, jobs will come. In the meantime, beware of politicians promising jobs programs – they might just be handing out spoons.

Charles E. Osborne, CFA, Managing Director

~JOBS

This fall, we commemorate the one-year anniversary of the financial meltdown of 2008. What a crazy ride it has been. In many ways this crisis actually has been good for our business in that we have gained several new clients, I – like most of us – still wish it had never happened. Life seems to be getting back to a new normal, and seven months of positive returns have calmed nerves and somewhat restored portfolios. This calm has given me time to reflect on the past year.

For most of the past year it has been our role to calm our clients’ anger and fears. We have tried to rise above and to bring rational thought to what was an emotional rollercoaster. We feel privileged to have helped our clients through this process and to have been the grateful recipients of unsolicited gratitude as well as the sounding boards to whom some of our clients have vented. I am proud of the Iron Capital team and the fact that we have performed far better for our clients than most in the industry, and yet I wish we had done better still. Now that some calm is here, it’s my turn to vent a little.

There are many things that stand out in my mind over the last year, but none irritate me as much as the media coverage. Much to my dismay, somehow in 2008, I and everyone else who works in the financial industry became a “banker.” I’m not sure how this happened, but it did. Almost every story about the crisis describes all kinds of people as “bankers.” I have read about the bankers at Merrill Lynch, the bankers at Goldman Sachs, even the bankers at AIG.

I’m not sure if the average lay person can understand how distressing this is to those of us in the financial sector who are not, in fact, bankers. With all due respect to my banking friends (and I do have several), most of the rest of the financial world thinks of bankers in the same way novelist Tom Wolf describes them in A Man in Full – bankers are the people who finished last in their class at business school.

Of course the media are trying to simplify things by using a somewhat generic term. They don’t want to explain the difference between a retail banker, a commercial banker, an investment banker, an analyst, a trader, and a portfolio manager. Let’s just call them all bankers. What is the problem with this?

The problem is that it was the non-bank financial firms that got us into this mess. The epi-center of the financial crisis was Freddie Mac and Fannie Mae – government agencies, not banks. Bear Sterns was the first victim – not a bank. Lehman Brothers and AIG were the biggest problems – guess what, not banks. Yet over the last several weeks there has been much talk about the new regulations finally coming out of this. The grand total of these new moves is the consolidation of some of the various banking regulators and the creation of a Consumer Protection Agency to police bank products. These proposals may or may not be good, but they certainly do not address any of the issues exposed in the crisis.

This is not the only area where media coverage has let us down. As John Maynard Keynes once pointed out, “Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be.” Our modern media has certainly taken this to heart. The Nightly News should be renamed The Nightly Polls and Pundits, as this is about all we get. My favorite example is from a report I heard on CNN early one morning as I was about to board a plane. This was shortly before the ’08 presidential election and CNN was breaking a story about how most Americans blamed the Republicans for the crisis.

What ever happened to true experts? I could be wrong, but I believe we are living at the height of the uninformed strongly held opinion. I guess to prove that I would actually have to conduct a poll. Instead of experts, today we have opinion polls and political pundits. Benjamin Graham once said, “You are neither right nor wrong because the crowd disagrees with you. You are right (or wrong) because your data and your reasoning are right (or wrong).” Just because the poll said Americans think the Republicans created the crisis does not mean that is true – or false. It has no bearing whatsoever on solving anything.

I do realize experts are boring, and they typically do not present well. They tend to offer a long, detailed, often complicated analysis of the issues, and we no longer have the attention span to deal with such. After all, who needs to study books when you can simply find all the answers in a one-paragraph entry on Wikipedia.com?

This phenomenon is not directly related to the financial crisis, but it sure has impacted the aftermath. Barely one year from the apex of this crisis and revisionist histories are already being written. The problem is that the true causes of this crisis are very complicated, and our modern media doesn’t do complicated. They do pundits and polls.

One of the issues coming out of this era of the uninformed strongly held opinion is that pundits don’t just pick their point of view; they actually get to pick the facts. I have read several articles that will have a sentence beginning something this one from a recent issue of The Wall Street Journal: “The fact that our current troubles are the consequence of government’s withdrawal from the economy…” This is not, in fact, a fact. The person who wrote this obviously has never worked in our economy. Government is everywhere in our economy. The author may believe we have too little regulation, and he is certainly entitled to that point of view, but that is his opinion, it is not a fact. This is, in my opinion, the primary reason our politics have become so hateful: people with differing points of view can intelligently debate each other and remain respectful, but people who choose to make up facts cannot be reasoned with.

Unfortunately, this particular fiction is fast becoming consensus in government circles. The danger of this avoidance of the truth is that we will end up not addressing the actual causes of the financial crisis. If we don’t address all the causes we will be doomed to repeat this chapter of our history. It won’t be exactly the same, but we’ll face these issues again. To paraphrase Mark Twain, history doesn’t exactly repeat itself, but it sure does rhyme.

One year after the apex of this crisis, not only has government gotten off clean in the media consensus view, but the real attack is on capitalism itself. Michael Moore has a new movie out entitled “Capitalism: A Love Story”. I have not seen the movie but I have read interviews with Moore about it. In one interview Moore states, “Capitalism is evil and you can’t regulate evil.”

He goes on to argue that capitalism is a big scam that was devised by the rich to convince the regular folks that if they worked hard, they too could be rich one day. Moore says this is a big fat lie. I’m curious how Moore, the child of a secretary and a factory worker who has become a multi-millionaire movie producer, explains his own life story under this “big fat lie” theory.

Ayn Rand once said, “The hardest thing to explain is the glaringly evident which everybody had decided not to see.” The overwhelming superiority of capitalism over every other economic system is so glaringly evident that it is indeed difficult to explain. Yet people like Michael Moore condemn the very system that makes their material existence possible. Moore is a poster child for capitalism, yet he condemns it.

Perhaps the best way to explain it is to go to the dictionary and define it. Dictionary.com defines it as follows: an economic system in which investment in and ownership of the means of production, distribution, and exchange of wealth is made and maintained chiefly by private individuals or corporations, esp. as contrasted to cooperatively or state-owned means of wealth. In other words, capitalism is simply a system of private property. When we think of property we tend to think in big wealthy terms, but property begins with a much smaller radius. It begins with your ownership of yourself. Capitalism is freedom, and to call it evil is the mother of all uninformed strongly-held opinions.

In The Seven Habits of Highly Effective People, Steven Covey points out that effective people focus on what they can control. In this article I have taken my turn to vent about what I think is wrong, however I have no control over the media, or public perception, or the overall direction of our nation. I and the rest of the staff at Iron Capital can control only how we react to these forces and how we allocate our clients’ money. The current attacks on capitalism and the resulting growth of government will have the same negative impact it has always had. In the 1930s and the 1970s, these same forces brought us economic stagnation, high unemployment and markets that were volatile but went nowhere. On the bright side, these decades also gave us investment greats like Benjamin Graham and Warren Buffett. There will be positive investment opportunities and we will find them for our clients. That is my pledge to you. This too shall pass, and the pendulum will swing back. Truth has a way of coming out in the end. We may be heading into a dark chapter, but the American story isn’t over yet.

Charles E. Osborne, CFA, Managing Director

~My Turn

“YET EACH OF US DEFINES THE LONG RUN WITH A DIFFERENT TIME SPAN IN MIND, WHICH MEANS THAT YOURS WILL BE APPROPRIATE FOR ME ONLY BY COINCIDENCE. NO MATTER HOW WE FIGURE IT, THE LONG RUN MEANS MORE THAN SHUTTING YOUR EYES AND HOPING THAT SOME GREAT TIDAL FORCE WILL BRING YOUR SHIPS HOME SAFE, SOUND, AND LADEN WITH JUST THE RIGHT MERCHANDISE FOR THE OCCASION.”  ~ Peter L. Bernstein

The investment world lost one if its shining stars this quarter with the passing of Peter Bernstein in June at the age of 90. The author of numerous books on economics and investing, most notably Against the Gods: The Remarkable Story of Risk, and founder of The Journal of Portfolio Management, Bernstein certainly belongs in the investing hall of fame. He spoke often about the misunderstood concept of long-term investing. He wrote: “The long run smooths the data by averaging out the wild volatility we experience in the short run. Therein lies its fascination. But therein also lies a mass of wishful thinking and oversimplification.”

Wall Street is broken – I believe we have made that point clear in our last two newsletters – but, what now? How do we get back to where we were and then on from there?

The first step is to understand the wisdom of Michael Price, legendary investor and founder of the Mutual Shares family of mutual funds, who said, “Wall Street is in the business of generating fees for Wall Street. Period. It is not in the business of getting good investment results. You have to separate from Wall Street to do that.” Wall Street also has dominated the communication to and education of the average investor over the last twenty years or more. That education is primarily marketing and while not un-true, it is filled with a mass of wishful thinking and oversimplification. Let’s debunk some of those oversimplifications.

I HAVE NOT ACTUALLY LOST MONEY UNTIL I SELL. This idea has become so ingrained in investor  behavior that psychologists have created a name for it: the ‘break-even effect.’ People hate to admit a mistake, and holding onto losers until the value comes back makes one feel as if nothing was ever lost. We saw this in our clients last year and earlier this year as many questioned why we were reallocating their accounts, causing them to realize losses. We hear this from prospective clients, who wish they had been with us last year but don’t want to move until they have regained at least some of their losses.

This doesn’t impact just the lay person; many professionals fall into the same trap. In his book Your Money and Your Brain, Jason Zweig cites a study of mutual funds that got new managers. Researchers ranked the funds’ holdings from the best to worst return. On average, the new manager sold 100% of the worst-ranked securities, which implies the old manager was paralyzed by his own mistakes. The funds that cling most desperately to their losers underperform by up to five percentage points annually.

When Warren Buffett was a young man he spent a lot of time at the race track. On one particular day he lost money in the first race, so he decided to double down on the second race. He lost again. The trend continued all day until he had lost all of his money. The lesson he learned, which he says he still uses to this day, is that you don’t have to make it back the same way you lost it.

This does not mean you should simply sell out any time a price goes down – that would be another oversimplification. Sometimes a price drop is an opportunity, while other times it simply means what you own is not worth what you thought. The wise investor must be able to discern the difference.

ONE SHOULD SIMPLY “BUY AND HOLD.” This is the fallacy that Bernstein was debunking in the quotes cited earlier. Investing for the long term is, in our opinion, the correct way to invest. In the history of the market there is not one credible account of anyone who has been successful at rapidly trading in and out of positions for any prolonged period of time. That is not from a lack of data. Countless people fall for the allure of thinking they can beat the market by various timing strategies, but this is a loser’s game. It is wiser to invest for the long term. Warren Buffett once said, “Don’t own a stock for ten minutes if you don’t intend to own it for ten years.” This is a principle that we adhere to at Iron Capital.

Nevertheless, just because you intend to own a stock for ten years when you first buy it does not mean you should bury it in the back yard and forget it. I will bet my home that Warren Buffett would sell a stock two days after he bought it if someone came along and offered far more than Buffett thought it was worth, or if some new information came out that forced him to question the original decision. There does come a time to sell.

ASSET ALLOCATION DETERMINES RETURNS is another favorite oversimplification. People who promote this idea often quote a study by Brinson, Hood and Beebower, published in 1986, which examined 91 pension plans and concluded that asset allocation decisions determine more than 90% of the variability of returns. Financial advisers love this study and oversimplify it to the point that they will tell clients that it really doesn’t matter what funds you use… therefore those C-class shares that pay them handsomely are just as good as lower-cost, better-performing options.

Asset allocation, or more broadly portfolio construction, is indeed hugely important. The level of importance,  however, is dependent on how you invest in the various assets. As David Sewensen, chief investment officer of Yale’s endowment, states in Pioneering Portfolio Management, asset allocation is the most important factor in the performance of large institutional portfolios largely because they have chosen to make it so. Most institutions use several managers per asset class and they prefer managers who don’t stray too far from their index. Those constraints greatly limit any value an active manager could add, therefore any value added must come from asset allocation. The smaller and therefore more concentrated your portfolio, the more important security selection becomes.

With all the talk in the investment world about portfolio construction, it is shocking to me how few practitioners actually understand how to build a portfolio. This is without a doubt the number-one flaw we see in portfolios we inherit from other advisers. I can only recall one prospective client who has ever come to us with a portfolio that had a coherent strategy evident in its construction. Although the strategy was different than ours at the time, I told the prospective client that he had an adviser who obviously knew what he was doing and that he should stay with him.

Usually what we see is a hodge podge of funds, stocks and ETFs, with no coherent theme whatsoever. It is what a former colleague of mine used to call ‘the front page Wall Street Journal approach,’ because it looks like the investor got up every morning and put money in whatever happened to be on the front page of the paper that day.

So how do you construct a portfolio? The basic premise is simple. At any given time you want to have the most money in the area of the market that has the highest probability of performing well going forward. You must, however, balance that with the risk that you could be wrong, so diversify with investments that all have promise but are unrelated to one another.

So what does that mean for today? We must understand the world we are in, and realize that this is most probably not the world that we wish it to be. Focus on quality, as this economy is a long way from recovery and many weak companies are yet to fail. Realize that government intervention is here to stay for the foreseeable future. Vote how you will, but do not fight Washington with your portfolio – you cannot win that battle. Also understand that Washington’s backing may guarantee survival, but it does not guarantee success. Be wary of unproven industries propped up by their political popularity, since such popularity can change quickly. Realize that the world does not revolve around the U.S. and that while the last century was certainly ours, the odds are that this one will not be.

This is a time for active management. It is a time when it is critical to understand what we own, and what is happening to those businesses. We must be able to recognize the difference between short-term market volatility and actual deterioration of a security’s real value.

We are entering a period where the broad market may go nowhere as the broader economy goes nowhere, yet there will be clear winners and losers. We are entering a period where portfolio construction will really matter, and those who understand that should do well, but those who simply close their eyes and hope that some great tidal force will bring their ship home safe, sound, and laden with just the right merchandise for the occasion will most likely be very disappointed.

CHUCK OSBORNE, CFA, Managing Director

~Where Do We Go From Here?

The great philosopher and leader of the Jedi Knights, Yoda, nailed it. Last year was defined by fear – fear in the mortgage market that led to fear in the bond market that led to fear in the stock market that led to fear in the real economy. Fear defined us in 2008, and just like the wise master counseled a long time ago in a galaxy far far away, fear has led to anger.

We are mad and we aren’t going to take it anymore. In many respects this anger is justified. It is righteous anger at the audacity of those who got us into this mess. However, there are two major issues with this anger. First, anger does lead to hate, which does lead to suffering, and most of the time that suffering is done by those who are angry, not by those on whom the anger is focused. Anger eats one up inside and leads to irrational decisions that are not necessarily in anyone’s best interest.

Secondly, and perhaps more importantly in this case, much of the anger is mistakenly aimed at “the rich” as an entire class, and at capitalism itself. The anger was intensified by bonuses paid to employees of firms such as AIG and Merrill Lynch, and most recently Freddie Mac and Fannie Mae. People certainly have a right to be mad. These were the very organizations that led us down this destructive path. But the anger is not stopping there. People are angry that some people get large bonuses period, and they are blaming it all on capitalism.

What they don’t understand, and to a certain extent what the people who got us into this mess didn’t understand, is that Wall Street is not capitalism, and the free market is not the stock market. Living in a free-market capitalist society on a daily basis has more to do with the grocery market than the stock market.

Free-market capitalism is about your right to shop where you want to shop or work where you want to work. If you want to start your own business, you can, since you are free. Companies are free to compete and consumers are free to choose.

Wall Street, or more correctly the capital market, is not the “system;” rather, it is a helper to the system. We seem to have lost track of that reality. Twenty years ago, Wall Street consisted of mostly independent firms who were focused on raising capital for successful businesses or managing investments. Internally we referred to the two sides of Wall Street as the “sell side” and the “buy side.” The sell side was made up of investment banks and broker-dealers that focused on helping companies grow by providing access to capital through the stock and bond markets. The buy side was made up of investment advisory firms that helped institutions, such as pension funds, and individuals buy stocks and bonds for investment purposes. The two sides were completely separate and combined represented less than 18% of the total corporate profits of the US. Most of these firms were partnerships, not publicly traded companies, and the risks they took were borne directly by the partners and clients.

Today, these lines have been blurred. Most Wall Street firms are publicly traded companies whose risks are borne by the shareholders and clients, not by management. They have grown to represent 41% of the US corporate profits as of the end of 2007. They are in all sides of the business even though this represents huge conflicts of interest. They are no longer interested in helping companies or in helping investors. Their only interest is in manufacturing products that are profitable to them.

One amazing aspect of the financial services industry is that they were seemingly able to create their own demand for any product they wished to push. At the beginning of this decade, I was still at Invesco. AIM, Invesco’s mutual fund division, was introducing separately managed accounts. These were mutual funds without the funds. Clients would get their own accounts with all the underlying securities that were in the mutual fund, for over double the price of the mutual fund. I asked why we were doing this, because it seemed insane to me that anyone would pay more than double for what is essentially the same thing. I was told that there was “huge client demand.”

I have never been one to simply believe what I am told, so I did some investigating and began asking people who had invested in these products why they did it. Every single time, I was told that they did it because that is what their broker recommended. I even had some people ask me, “Why is my broker ’pushing‘ these accounts?” Granted my investigation falls short of a true scientific survey, but I will bet the farm that there was zero true client demand for so-called separately managed accounts. The demand was created by the Wall Street firms themselves.

Why the firms wanted these instruments is obvious – they get the lion’s share of the fees, and more importantly, 100% of the trades. Clients don’t balk because these trades are “commission-free.” What clients don’t understand is that commissions are just the beginning of trading costs that go to the Wall Street firm. The only reason someone would invest in these products is to make more money for the Wall Street firm.

The firm tells their brokers to push this product, and they do what they’re told. Clients believe their brokers are “advisers” with only their best interest at heart, so they agree. How do these people sleep at night? They are protected by layers. The money managers never meet the clients. Many firms have even created a position called “client portfolio manager” who poses as the money manager if larger clients insist on meeting someone, but they are not actually the manager. Most money managers don’t care to meet the client and rarely give the client a thought, because they are doing what they love, getting paid well for it, and dealing with the client’s best interest is someone else’s responsibility. That responsibility falls on the shoulders of the broker, but the brokers aren’t investment professionals and don’t know anything about investing that they have not been told by their bosses, who are telling them to push this product.

Nowhere has this pattern been clearer than in the explosion of “alternative investments.” The argument goes that an investor should diversify away from stocks and bonds. They should invest in commodities, emerging market stocks, and – always included in the list – hedge funds. We are told that hedge funds are very risky, so we should not invest in just one hedge fund, but in a fund that invests in other funds. So the investor goes to an adviser who recommends a hedge fund “fund of funds” because that is the latest craze. The manager of the fund of funds gets paid a fee, the actual hedge fund managers get paid a fee, and the broker gets paid a fee. The only person who doesn’t make out in this deal is the investor, whose profits are eroded by everyone else’s fees.

The defenders of these strategies will say they are emulating the huge success of college endowment managers at places like Harvard and Yale. Unfortunately for them, David Swensen, the Chief Investment Officer at Yale, calls the fund of funds a “cancer.” Warren Buffett has made a well-publicized bet that one of the largest of these fund of funds will not be able to beat the S&P 500. These legendary investors understand that one simply cannot overcome the layers of fees.

These layers explain why Wall Street has gone from 18% to 41% of the US economy. They exemplify what is wrong with Wall Street and why people are so angry. Americans are not angry simply because some people got rich over the last 20 years; they are angry because they got rich by ripping people off instead of by building real companies that provide valuable products and create jobs that enrich others.

We must get back to the basics. Wall Street needs to focus once again on helping companies access capital to grow, and on helping investors invest in those companies. We must provide investors with direct access to expert investment counsel. The only way that will happen is if investors refuse to do business with the retail arms of the big Wall Street firms. If you are angry about what has happened, then take action and close any accounts you have with Wall Street firms. Then let your anger go before it does turn to hate and then to suffering, because the suffering most likely will be your own.

CHUCK OSBORNE, CFA, Managing Director

~Anger Management

AIG has become a ward of the state. There are no longer any big independent Wall Street investment banks. The market has crashed. Madoff stole a record $50 billion. Etc. If the historical events of 2008 have taught us anything, they have taught us that Wall Street is broken. The natural questions are: what went wrong, and how do we fix it?

The most common response to the first question is simply greed. However, I don’t believe greed is the problem. For those who now expect me to echo the sentiment of Gordon Gekko (Michael Douglas’ character from the movie “Wall Street”) and say that greed is good, I hate to disappoint. Greed is not good in my opinion. The problem with simply saying the cause of this crisis was that people on Wall Street were greedy is that in order for that to be true, either there must have been a time when people on Wall Street were not greedy, or there has actually never been a time when Wall Street has worked. I seriously doubt there is anyone who would argue the former, and while there are probably some extremists who would argue the latter, the evidence against this argument is overwhelming.

I have thought long and hard on this issue, and greed, while certainly a factor, just didn’t seem to fully explain this crisis. Something was missing. The words of an old mentor kept coming back to me. In large complex organizations, the vast majority of problems are caused by structural issues, not human fallibility. Wall Street is structurally broken, and it is going to take more than a spiritual revival to fix it.

To understand why Wall Street is broken, you must first understand why Wall Street exists in the first place. What is Wall Street’s purpose? Wall Street exists to bring together people with business ideas with people who have capital to invest. This is the essence of capitalism: Investors decide what companies will be provided the capital they need based on the merits of their business plans, not on some central plan devised by government leaders or on political connections. Capital is free to flow to the best business ideas. These companies use that capital to build plants, to create products that people actually want to buy, and to create jobs and prosperity.

For all of its history, Wall Street and the investment banking firms that had come to represent it have financed American industry. The railroads, steel, oil, automobiles, computers, and the Internet were all financed by Wall Street – real industries made up of real companies that produced real products and real jobs. The business managers would come to Wall Street with their ideas and plans, and the investment banks would underwrite loans in the form of bonds, or ownership stakes in the form of stock. The investment banks would take those stocks and bonds and distribute them to investors through their brokerage offices around the country. These investment banks made money by charging fees to the companies they helped and by charging commissions on all the stocks and bonds they sold to investors around the country.

Then something happened starting in the 1980s. Technology along with advent of the discount broker started putting pressure on all those commissions. It became more and more difficult for the big Wall Street firms to charge those high commissions on simple stock and bond transactions. At the same time the work of Harry Markowitz, the founder of modern portfolio theory, was becoming more accepted, and the concept of risk management was becoming popular in the investing world. Everything you know about diversification, risk and return all came from the work of Markowitz.

This desire for diversification, along with the introduction of the 401(k) plan, helped launch the mutual fund industry.

Here is where it is important to understand how “investment education” for the masses gets disseminated. For Wall Street to push a concept, it must be generally correct (they would not be so foolish as to push out and out lies), but it also must be profitable to Wall Street. Mutual funds were very profitable. All of a sudden the average client who might invest in ten to twenty stocks and bonds could be sold a mutual fund instead. The fund invested in hundreds of stocks and bonds. And guess what, the mutual funds buy and sell stocks and bonds the same way anyone else buys and sells stocks and bonds – through Wall Street brokerages. Sure, they pay lower institutional commission rates, but they make up for that in volume and also tend to trade far more often than the average investor.

But that is just the revenue that happens behind the scenes. On top of all that, the Wall Street brokerages still got commissions from selling the funds themselves, and they got a piece of the ongoing management fees. As brokers started shifting away from selling individual stocks and bonds towards selling funds, they had to come up with new ways of explaining their purpose, i.e. “adding value.” After all, picking funds didn’t seem nearly as hard as identifying a lucrative stock, especially early on when there were not as many funds out there. So they became “advisers.” That is when Wall Street really embraced Mr. Markowitz and his theory. Owning one mutual fund is not enough; one must own several funds that invest in different types of investments.

Now the average client, instead of buying ten to twenty stocks and bonds – ten to twenty transactions for Wall Street, or one hundred stocks and bonds in one fund – one hundred transactions for Wall Street, can own thousands of stocks and bonds – thousands of transactions. Plus the fees, oh the fees – how wondrous were the fees!!

Over the years as the mutual fund industry matured, fees became more competitive and Wall Street firms could no longer make as much. To reduce costs, mutual fund managers became wiser about how they traded. Today that party is over and an investor can find low cost mutual funds that make sense. But, Wall Street had learned its lesson. Selling products was much more profitable than just distributing stocks and bonds.

Next came the so-called separately managed account. You could have the mutual fund manager manage your money without the mutual fund. Now all the underlying stocks and bonds were custodied with your brokerage firm and you could see them on your statement if you wish. In addition, your brokerage firm got a much bigger piece of the management fee, which – because these were “custom” – was 2.00% to 3.00% instead of 0.50% to 1.00%. Wall Street had figured out how they could create a mutual fund where they got more of the money than the mutual fund manager.

By now we were in the 21st century and the market had started to come down from its twenty-year run through the 1980s and 1990s. Hedge funds, however, were making money. Up until now these had been little-used and talked-about instruments for the rich. But, hedge funds were able to sell short, and when the market is heading down, selling short seems like a good idea. In addition, these funds were even better than separately managed accounts because they used margin. Wall Street makes a lot of money off of investors who use margin, because the investors have to pay interest on that margin. They also make bigger transactions – higher commissions, and they sell short – higher commissions still. On top of all of that, hedge fund managers trade even more frequently than mutual fund managers – once again, higher commissions.

All of that money is made by Wall Street before the hedge fund even charges the client their fee. Because these instruments are so “sophisticated,” charging the 2.00% to 3.00% you would pay for a separately managed account is simply not enough. They must charge 2.00% plus 20% of any gains.

Wall Street lost sight of its true purpose, and instead of simply providing capital to business managers, they started creating products. The more complicated they made them, the more profitable they became. They could turn anything into a product. Mortgages? No problem – securitize them. They don’t pay enough? No problem – add some leverage. Risk? We will create products that spread the risk to multiple counterparties.

Oh, by the way, those counterparties all have to get paid too, but that is alright – what goes around will come around, we are all in this together. Right up to the point when it implodes.

Some have said the crisis of 2008 is a failure of the capitalist system. I wanted to check it out, so I went directly to the source: the capitalist bible, Adam Smith’s The Wealth of Nations. It had been a long time since I had read it, but I did not recall the chapter on Collateralized Debt Obligations. I had no recollection of Mr. Smith’s view of Credit Default Swaps, or even simple Mortgaged Backed Securities. When I picked the book back up I discovered why I had no recollection of these things. They are not there. Capitalism is not about complicated financial products. It is about the ownership of companies. Capitalism isn’t represented by Wall Street or hedge fund managers; it is best represented by small business owners – real people with ideas who want to create something real.

Wall Street is broken. To fix it, we must get back to basics. We must move away from buying its products and playing the market, and get back to investing in companies – real companies that produce real products and create real jobs.

CHUCK OSBORNE, CFA, Managing Director

~What’s Wrong with Wall Street?