CFA Institute

Passion for Reality: Paul Cabot and the Boston Mutual Fund. 2006 by Michael R. YoggReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 64, No. 3 (May - Jun., 2008), pp. 96-97Published by: CFA InstituteStable URL: http://www.jstor.org/stable/40390218 .

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Martin S. Fridson, CFA Editor For more critiques of books that are relevant to practitioner work, please visit our Book Review service at www.cfapubs.org.

Passion for Reality: Paul Cabot and the Boston Mutual Fund. 2006. By Michael R. Yogg. Xlibris Corporation, (888) 795-4274, www.Xlibris.com. 242 pages, $28.79.

Reviewed by Martin S. Fridson, CFA.

As cof ounder of State Street Research & Management Company (SSR&M), Paul Cabot (1898-1994) played a pivotal role in one of the most successful financial innovations of the 20th century, the open-end mutual fund. His firm was also at the forefront in the evolu- tion of fundamental stock analysis. (The book's title alludes to Cabot's insistence on gathering all the per- tinent facts before making an investment decision.) In addition, Cabot was an effective advocate in Washing- ton, DC, for the industry he helped create.

In Michael R. Yogg's biography of this invest- ment legend, Passion for Reality: Paul Cabot and the Boston Mutual Fund, ethics is a central theme. Cabot won a reputation for probity during the 1920s by decrying unscrupulous practices of investment trusts. Forty years later, he again captured national attention by warning his alma mater, Harvard University, against the "dangerous, unfair, unwise, and possibly disastrous policy" of using capital gains, rather than income alone, for current expenditures. At the time, Ford Foundation president McGeorge Bundy was vigorously promoting total return as a benchmark for spending limits. Many endowment funds regretted taking Bundy's advice when the disastrous bear mar- ket of 1973-1974 sharply depleted their principal.

Yogg, a money manager who worked at SSR&M from 1978 to 1996, writes that he liked and admired his subject. He nevertheless manages to tell a story more nuanced than a simple morality tale featuring Paul Cabot.

In the U.S. SEC investigation that led to passage of the Investment Company Act of 1940, conflicts of interest were a key focus. The SEC questioned Cabot's decision to serve simultaneously on the boards of SSR&M and National Investors Corporation, a Detroit-based mutual fund organization. Cabot received directors' fees from National Investors (in the form of options that ultimately became extremely valuable) at the same time that National Investors was benefiting from the work of SSR&M's research staff.

Martin S. Fridson, CFA, is CEO of FridsonVision LLC, New York City.

Yogg states that, although Cabot's actions were legal at the time, cleared by his lawyer, and fully disclosed, they had the appearance of conflict and would be challenged in today's environment.

Yogg further points out that, although Cabot urged Harvard's endowment not to spend capital, his own fund did essentially that in the stock market trough of 1932. State Street shifted $10 million of capital to surplus to maintain its dividend payout. (In Yogg's view, Cabot's criticism of Bundy's spending proposal was wrongheaded in any case because it defended an outdated and artificial accounting distinction.)

Another potential conflict arose when Cabot con- tinued his active role at SSR&M while serving as treasurer of Harvard beginning in 1948. The univer- sity agreed that under certain circumstances, his firm's transactions could take precedence over Harvard's. Yogg notes that, even if it could be proven that the university was not harmed as a consequence, "an arrangement in which Harvard took a back seat to State Street would not be permitted today, espe- cially since so much of [Cabot's] personal money was at State Street."

As late as 1971, Cabot opposed the idea of incor- porating a mutual fund's management company and selling out to a financial institution. He believed that the management group's contract with the fund belonged to the fund and that management had no right to profit from selling it. According to Yogg, Cabot regarded SSR&M's original structure, in which retiring partners sacrificed substantial profits by sell- ing their shares back at book value, to be "a moral imperative." Nevertheless, in 1982, Cabot, who had long since retired, acquiesced to the sale of SSR&M to Metropolitan Life Insurance Company. Yogg rejects any suggestion that his advanced age rendered him incapable of understanding the transaction or resist- ing the active partners' cajoling.

These inconsistencies over the course of several decades probably should not be interpreted as lapses. Rather, they demonstrate that ethical standards do not emerge fully formed and forever unchangeable but evolve over time. Individuals revered for recti- tude may engage in practices that appear question- able years later, after the profession raises the bar on proper conduct. Readers may not unanimously agree that financial professionals' conduct has improved over time, but the definition of ethical behavior surely has been tightened, thanks in part to CFA Institute

"Book Reviews" is a regular feature of the Financial Analysts Journal. The views expressed herein reflect those of the reviewer and do not represent the official views of the FAJ or CFA Institute.

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Book Reviews

and its predecessor organizations (the Association for Investment Management and Research, the Institute of Chartered Financial Analysts, and the Financial Analysts Federation).

In addition to shedding light on ethical issues, Passion for Reality provides useful insight into the history of the investment management business. The book also contains many colorful anecdotes about Cabot and his acquaintances, including John F. Kennedy, John Kenneth Galbraith, and an important early leader of Goldman Sachs, Sidney Weinberg. Drawing on a font of oral history, Yogg tracks the increasing openness of upper-class Boston society during the past century.

Aside from ethical matters, the main investment issue addressed by Yogg is the efficacy of fundamen- tal analysis. He reports that SSR&M outperformed the S&P 500 Index by a margin of 39.8 percent to 15.4 percent (annualized rates) during the bull market of the late 1920s. According to Yogg, this performance is the sort of result one would expect to derive from meticulous securities analysis in a highly inefficient market. SSR&M's less spectacular, albeit respectable, performance edge in later decades seems, on the premise that the spread of fundamental techniques eliminated gross mispricings, to support that thesis.

SSR&M's methods, however, were by no means infallible. The partners suspected something was not right about swindler Ivar Kreuger's Swedish Match empire but did not act swiftly enough to escape the damage when the scheme collapsed in the 1930s in a massive accounting fraud.

Passion for Reality is handsomely presented, with Cabot's 25th college reunion photograph gracing the dust jacket. Editing errors are few and of the garden variety (e.g., one-time governor of Maine Tudor Gar- diner's surname spelled both correctly and incorrectly within the same paragraph, the second "t" omitted from Warren Buffett's surname). Regrettably, Yogg quotes a remark of Cabot's that perpetuates the long- discredited myth that brokers jumped out of the win- dows of Wall Street office buildings during the stock market crash of 1929.

Notwithstanding these minor flaws, Passion for Reality is an intelligent and well-written account of the career of an important figure in the formation of the modern investment management business.

- M.S.F. The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do aboutit 2008. By Louis Lowenstein. John Wiley & Sons, Inc., (800) 762-2974, www.wiley.com. 220 pages, $29.95.

Reviewed by Martin S. Fridson, CFA.

The average investor in an equity mutual fund earned an annualized return of 5.8 percent over the 1996-2005

Martin S. Fridson, CFA, is CEO of FridsonVision LLC, New York City.

period versus 9.1 percent for the S&P 500 Index.1 This statistic alone makes a prima facie case that, as the author of The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do about It con- tends, mutual funds are not being run for the benefit of investors. Louis Lowenstein, the Simon H. Rifkind Professor Emeritus of Finance and Law at Columbia University, marshals voluminous research to indict the mutual fund industry for straying from the customer- oriented ideals with which it was launched more than 80 years ago.

Lowenstein shows that transaction costs and fees, although higher than they should be, do not fully explain why so little of the underlying stocks' returns reach fund shareholders. He argues that the funda- mental problem arises from fund managers' determi- nation to maximize assets under management (AUM) in order to capture the attractive economies of scale that the business offers.

A cornerstone of mutual fund companies' asset- gathering strategy is market segmentation, a technique previously perfected by consumer goods producers. Management firms offer a dizzying array of funds concentrated in categories, such as large-capitalization growth, mid-cap value, and small-cap international, as well as industry and country funds. The role of portfo- lio managers is to avoid "style drift" by staying strictly within their designated silos. Suboptimal investment performance is an unavoidable consequence of this approach to fund management, in Lowenstein's judg- ment. Investors would capture far more of the market's inherent return, he says, if portfolio managers operated under broad mandates with discretion to pursue rela- tive value wherever it might appear.

In the early days of the mutual fund industry, the inherent conflict between maximizing AUM and achieving the highest possible return for investors was kept in check by the prevailing industry structure and legal doctrine. Fund management companies were small, private firms that were barred from selling their own shares to outside investors. The U.S. SEC deemed the "excess value of the management contracts" an asset of the mutual funds themselves that, as such, could not be sold for a profit by the owners of the management firms. A 1975 amendment to the Invest- ment Company Act, however, legalized such sales.

Lowenstein maintains that as soon as manage- ment firms got the chance to go public or sell them- selves to major financial institutions, their focus shifted. Instead of trying to deliver long-term perfor- mance through the patient, Graham and Dodd approach that Lowenstein favors, they turned to hawk- ing inferior, narrow-gauge funds to exploit consumers' weakness for the flavor of the month. Funds that beat the averages were advertised heavily - but tended to perform poorly following the resulting influx of new assets. Hiring a broker to help pick the best fund proved to be no panacea for investors because of

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