Frank Thoughts: Rising Interest Rates and Dispersion
Frank Boland
February 09, 2022

A pale green Pontiac Bonneville had just pulled up to the front of my parent’s two family house. The car was a “monster.” It “dripped” of chrome and weighed in excess of 5,000 pounds. At the time, I was a 12 year-old caddy as was Peter Lynch. It was 1955 and that car was a major status symbol. The man who owned the Bonneville had been an army buddy of my father’s ten years earlier in the war. But that day he was an investment salesman selling a “Contractual Plan” for Fundamental Investors, a mutual fund. A product that cost 8.5% a year. Not 1%. Yet the man believed he was helping my dad.

 And he was. As I came into the house, I saw a leather brief case on the living room floor and stock charts scattered everywhere. The charts showed the performance of the fund for the previous 10 years. It was astonishing! The Dow Jones Average had increased in that period 334%. But the fund had increased somewhere between 75 -100% more! My father signed the contract for a $100 a month payment for 10 years.  However, because there was a commission for the first five years, just $92.50 went into investing.  My father didn’t care and, undoubtedly, no one else did at the time either.

It would be decades later before I would learn about correlation, portfolio dispersion and the crucial impact of interest rates on portfolio performance. In 1955, no one knew. Even today, most investment “professionals” do not. That’s certainly true of individual investors. There exists now an unwritten categorical law of investing that, no one can beat the S&P 500 because of the 1% fee. Forgotten in this moral certainty of universal acceptance, is that there was once a similar crowd experience in 1633. At that time, the church – and the crowd - believed the sun moved around the earth. Galileo disagreed.

The possibility of active portfolio management’s failure being the result of the 1% fee was suggested in 1975 by the then Harvard Business School Professor, Charlie Ellis.  In an article titled, The Losers Game, he posited that, “The investment business is based upon a simple and basic belief. Professional money managers can beat the market. That premise appears false.” It was written after the worst bear market since the depression. Totally ignored – or not understood – is that interest rates were in a secular rising trend. Also not foreseen was Peter Lynch’s phenomenal 13 year record starting in 1977.

The genesis of it is the direction of interest rates. Today we have an advantage; we know Fed funds are going higher. Today’s fee misconception was preempted by Jerry Tsai and Fidelity Investments in 1958. Fed Funds had started at 1.4% in 1955. Over the ensuing 27 years, Fed Funds would move on a secular basis to the record level of 20% in 1982. This created enormous dispersion in the stock market. Dispersion is a statistical term which indicates a wide range of possible returns. It allows a portfolio manager to demonstrate his/her skill in choosing individual stocks. Joe Mc Nay is the prime example.

Joe Mc Nay was the ultimate winner in historic portfolio management performance. In that summer of 1955 Joe was graduating from Yale. His classmates put him in charge of their 25th year class gift of $300,000. In 1979 the class gave Yale their gift. It was $92 million! He had achieved a performance record of 23.5% a year … for 25 years!  Macro fear is always the cause of correlation but by the 1950s correlation had returned to a normal 26% of stocks traded. And as interest rates went higher so did individual stocks. Joe Mc Nay and Peter Lynch were very good at managing stock portfolios – arguably the best – but the dispersion created by rising interest rates gave them the opportunity.

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