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Thursday, November 30, 2023

Zeikel’s Rules – The Reformed Broker

It’s 1994 and the Thundering Herd is in an absolute uproar. Merrill Lynch’s fabled brokerage salesforce is furious about the recent performance of all the closed-end bond funds they had sold their clients. Fed Chairman Alan Greenspan had shocked the market with a series of rate hikes and bonds had gotten slaughtered.

Closed-end funds were the vehicle of choice through which retail investors got their exposure to the bond market. They bought these portfolios in a wrapper that traded on the New York Stock Exchange for either a slight premium or discount to that portfolio’s NAV or true value. Brokers loved selling closed-ends to their clients because these funds would often pay above-market yields by utilizing leverage and some riskier positions baked into the pie. Not to mention the selling concession a broker could earn from selling the initial public offering – an inside commission built into the share price that clients didn’t even see. Everybody wins.

But not that spring. It was a nightmare. Customers were mad, which makes the brokers mad, which scares the “home office” folks into feeling like they need to do something – anything – to relieve the pressure. “Let’s just shut down the whole thing,” you can imagine them saying. According to the guy who oversaw Merrill Lynch’s municipal bond funds, there was talk of exiting the business entirely. But Arthur Zeikel, President of Merrill Lynch’s asset management business, said “No, this is no time to panic.” He stuck to his guns. Within a year, these funds had fully recovered.

You may have heard the name Arthur Zeikel late last year when he passed away at the age of 89. There was a Wall Street Journal obituary and anyone who worked in the brokerage or asset management business on Wall Street in the 80’s or 90’s remembered him. After spending some time at Dreyfus and Oppenheimer, Merrill Lynch brought him in to take its tiny asset management business to the next level. The year was 1976, investors had been chased out of stocks by the raging volatility of the prior years and cash management was the hottest retail product within the firm. Moving investor capital out of cash and into stocks and bonds wouldn’t be seen as the obvious win it turned out to have been for at least a decade. The 1970’s were an inhospitable time for risk-taking investors and no one was particularly interested in long-only mutual funds.

This apathy probably gave Zeikel the cover he needed to experiment. It bought him time to nurture the talent of his portfolio managers. He was given free rein to innovate and create new funds, focusing on the basic principals of value investing. As the 1980’s bull market took off and interest rates fell, his asset management products were a hit with Merrill’s nationwide salesforce. Zeikel cultivated relationships with the big players in all the branches – that’s how you excel in asset management: Distribution is everything.

In 1999, Zeikel’s value discipline had fallen out of favor as the Nasdaq’s growth stocks were booming and the investing public became captivated by the siren song of Janus and Munder and Firsthand and a new class of fearless fund families that charged headlong into the bubble. He was replaced by outsiders who were brought in to put Merrill back in the hunt. The new guys went all in just as the dot com bubble was peaking. You know how it went from there. By 2001, as the asset management industry looked inward with shame and embarrassment, a task force was being convened to determine how so many analysts and fund managers could have led their investors astray. Arthur Zeikel came out of retirement to chair this task force.

By 2006 the Merrill Lynch asset management unit he’d built was sold to BlackRock for $9.5 billion worth of stock, giving Merrill a 50% stake in the combined company. They would eventually sell this stake back to BlackRock by 2011 during the financial crisis. The sale of this unit would become the foundation for what is now the largest asset manager in the world – with almost $10 trillion under management, including the descendants of those bond funds that had been at the center of the controversy during their moment of poor performance in the mid-1990’s.

If you ask people who worked with him, they’d say that Arthur Zeikel’s strong suit was that he never gave up on a portfolio manager going through a rough patch. He understood that sometimes sound investment strategies go out of favor. In the obituaries after his passing this December, this quality of his was noted. As was the fact that he was way ahead of his time in terms of incorporating the behavioral aspect of investing into his work. In times like these, when the bombs are falling and the new 52-week low list is littered with blue chip stocks, your behavior becomes the only thing you can control.

Sometime in 1995, Arthur Zeikel published some investing advice to his daughter Jill. He had written it shortly after enduring the closed-end bond fund revolt as Merrill’s Executive Vice President of the Asset Management Group. He was 63 years old, having spent almost four full decades on The Street. I share it with you now because there’s a timelessness here that I believe makes it entirely apropos of the current situation we find ourselves in. I hope it helps you. – Josh



From: Arthur Zeikel (Father)

To: Jill Anne Zeikel (Daughter)

Date: Oct. 17, 1994

Re: Managing Your Own Portfolio

Personal portfolio management is not a competitive sport. It is, instead, an important individualized effort to achieve some predetermined financial goal by balancing one’s risk-tolerance level with the desire to enhance capital wealth. Good investment management practices are complex and time consuming, requiring discipline, patience, and consistency of application. Too many investors fail to follow some simple, time-tested tenets that improve the odds of achieving success and, at the same time, reduce the anxiety naturally associated with an uncertain undertaking.

I hope the following advice will help:

A fool and his money are soon parted. Investment capital becomes a perishable commodity if not handled properly. Be serious. Pay attention to your financial affairs. Take an active, intensive interest. If you don’t, why should anyone else?

There is no free lunch. Risk and return are interrelated. Set reasonable objectives using history as a guide. All returns relate to inflation. Better to be safe than sorry. Never up, never in. Most investors underestimate the stress of a high-risk portfolio on the way down.

Don’t put all your eggs in one basket. Diversify. Asset allocation determines the rate of return. Stocks beat bonds over time.

Never overreach for yield. Remember, leverage works both ways. More money has been lost searching for yield than at the point of a gun (Ray DeVoe).

Spend interest, never principal, If at all possible, take out less than comes in. Then a portfolio grows in value and lasts forever. The other way around, it can be diminished quite rapidly.

You cannot eat relative performance. Measure results on a total return, portfolio basis against your own objectives, not someone else’s.

Don’t be afraid to take a loss. Mistakes are part of the game. The cost price of a security is a matter of historical insignificance, of interest only to the IRS. Averaging down, which is different from dollar cost averaging, means the first decision was a mistake. It is a technique used to avoid admitting a mistake or to recover a loss against the odds. When in doubt, get out. The first loss is not only the best but is also usually the smallest.

Watch out for fads. Hula hoops and bowling alleys (among others) didn’t last. There are no permanent shortages (or oversupplies). Every trend creates its own countervailing force. Expect the unexpected.

Act. Make decisions. No amount of information can remove all uncertainty. Have confidence in your moves. Better to be approximately right than precisely wrong.

Take the long view. Don’t panic under short-term transitory developments. Stick to your plan. Prevent emotion from overtaking reason. Market timing generally doesn’t work. Recognize the rhythm of events.

Remember the value of common sense. No system works all of the time. History is a guide, not a template.

This is all you really need to know.

Love, Dad

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