Capital Ideas. Bernstein Peter L.

funds are not subject to the capital gains taxes that hobble profit-taking by individuals, professional portfolio managers now began to have more fun.

      This flood of new money, especially tax-free money, pouring into the marketplace soon transformed the traditional practices of comfortably ensconced trust officers and investment advisors. Competition goaded institutions into ever-higher levels of activity in their endless pursuit of rich returns. In 1967, my own organization, seeking a quick move into the big time, assented to being acquired by an aggressive young brokerage firm with a capital of only $1,000,000 that would keep on acquiring until one day it metamorphosed into one of the largest firms on Wall Street. Along with everyone else, we noticed that we were trading much more actively than in the old days, especially as more and more of the money we managed was exempt from taxation.

      The process has been a constant joy to the investment advisory profession. Just during the 1980s the number of investment advisors registered with the S.E.C. tripled, while the number of mutual funds more than quadrupled. Dave Williams, chairman of one of the largest mutual fund organizations, recently quipped that “investment management is the only professional enterprise in America with more competitors than clients.”5

      There are giants among them. Nearly 100 portfolio management organizations now have over $10 billion each under management. The ten largest manage $800 billion of financial assets out of an institutional total of some $5 trillion in stocks, bonds, and real estate. Citibank, which was number one in 1977 with $26 billion, would barely have made the top 25 in 1989.

      The tried-and-true methods of managing portfolios that my older partners taught me in the 1950s were ill suited to the management of the vast sums that accrued to institutions as the years went by. Everything had to be revised: investment objectives, diversification patterns, trading strategies, client contracts, definitions of risk, and standards of performance.

      The merry game of just picking the best stocks and tucking them into a client’s portfolio had worked well enough when portfolio management organizations were small. My firm, with less than $100 million under management when we were acquired, had no trouble running portfolios with less than twenty positions.

      As organizations grew in size, that scale of operations was no longer practical. Managers with $5 billion under management and with only twenty holdings in a portfolio have to put $250 million into each position. To accumulate such large holdings and to liquidate them later on tends to move stock prices so far that the sheer cost of transacting cuts deeply into the portfolio’s rate of return. Many of the go-go managers of the 1960s ignored that reality, and continued to act as though they were still managing small portfolios. Their innocent disregard of change helps explain what happened when stormy economic weather overwhelmed the optimistic markets of 1971 and 1972.

•••

      Before the revolution, the clients of our family-oriented business would come to us and say, “Here is my capital. Take care of me.” As long as their losses were limited when the market fell, and as long as their portfolios rose as the market was rising, they had few complaints. They came to us and stayed with us because we understood their problems and the myriad kinds of contingent liabilities that all individuals must face. They recognized that we shared the delicate texture of their views about risk. We joked that we were nothing more than social workers to the rich–but skilled social workers to the rich, confident that our performance was being measured in human satisfaction rather than in comparative rates of return. We knew no more about the clients of other investment managers than they knew about ours.

      But when corporate pension funds and university endowments replace individuals as the dominant clientele, the manager/client relationship undergoes a transformation. Social work goes out of fashion: personal relationships, though still important, grow more tenuous. Usually the person with whom the advisor deals must report to some higher authority who has no direct relationship with the advisor. The shareholders in mutual funds seldom know the names of the people who manage their money. Anyone who is interested can find out how much the General Motors Pension fund has to invest, whether Yale is dissatisfied with the way XYZ Associates has been managing their endowment fund, or how well ABC Management performed last year.

      As financial markets multiplied and as institutions and professional managers became the principal players, innovation was inevitable. But innovation must be preceded by theory. And the role of theory in the financial revolution took some surprising twists and turns.

•••

      The intellectual roots of most revolutions reach back to men and women who are also deeply involved in motivating what happens. Not so the makers of the revolution in finance. None of the pioneering work in either theory or practice was done in New York, the greatest financial market in the world. Most of the pioneers were professors with a taste for higher mathematics, strange bedfellows for the hard-nosed veterans of boom and bust. Few of them ever played the market with more than a few thousand dollars of their own. Nor did they shout their theories from the rooftops. With only a couple of exceptions, they were content to publish their ideas in academic journals and to debate them with their colleagues.

      When their articles began to appear in the journals, adorned with fancy equations made up of Greek symbols, the few investors who were aware of them considered their ideas a joke dreamed up by a bunch of egg-heads who had never owned, much less managed, a portfolio. One distinguished practitioner, in an interview in 1977, dismissed their theorizing as “a lot of baloney.”6 Another referred to them as “academia nuts.”7

      When three of them were chosen to share the Nobel Prize in economic sciences in October 1990, few outsiders had the slightest idea of who they were, what they had done, or why they deserved the most coveted prize in economics, a discipline that itself was slow to claim them as its own. One of the laureates remarked that their receiving the Nobel Prize was “sort of like the Chicago Cubs winning the World Series.”8

      For most of the scholars who pioneered the revolution, coincidence rather than any ideological passion determined the course of their work. One was a college varsity football star who had originally planned to teach French. Another was an astronomer. One dismissed his early fascination with finance as “a terrible mistake.”9 Others had settled on mathematics, engineering, and physics as their chosen fields. Such partiality may explain why most of them viewed the stock market as nothing more than a rich source of data and fascinating intellectual puzzles.

      Another major player in the revolution was the computer itself. None of the theories we shall be describing here could have had any practical applications, or could even have been tested for its real-world relevance, had this revolutionary device not been available. Its extraordinary capabilities opened the way to theoretical frontiers that might otherwise have remained hidden. By transforming the sheer mechanics of financial transactions, the computer shaped their outcomes as well.

      As theories about how capital markets function and how investors should manage their affairs are latecomers in the history of ideas, all but three of the principals in this story are still alive, and only four of them are over sixty years old. I sat with each of them for hours at a time, asking where their ideas had come from, how they developed and applied them, and what they had experienced during their unpredictable journey.

      They told me that to conceive and develop a new theory is a high adventure. Though many of them were somewhat shy, none was faint-hearted. Moments of silent contemplation alternated with spirited disagreements with the views of colleagues and other theorists. If the answers they were seeking had been obvious, they explained, someone else would already have uncovered them. Francis Crick, a co-discoverer of the structure of DNA, once described the path of discovery this way:

      I think that’s the nature of discoveries, many times: that the reason they’re difficult is that you’ve got to take a series of steps, three or four steps, which if you don’t make them you won’t get there, and if you go wrong in any one of them you won’t get there. It isn’t a matter of one jump–that would be easy. You’ve got to make several successive jumps. And usually the pennies drop one after

5

Wien (1990).

6

Institutional Investor staff (1977).

7

The editor of this book read the term in a journal article of the 1970s.

8

Vosti (1990).

9

Treynor, PC&I.