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When I talk to other money managers, I typically interact with intelligent investors who "get it," which is to say that they manage money under systems and philosophies that work, and they generally deliver great service and performance to their clients. So occasionally, I wonder about how people less capable and less informed manage money.

Today I got the chance to see. A new prospect asked me to review his current investments, which have been managed since April 2003 by his broker at Morgan Stanley, a broker who happens to be a "great guy," a friend of the family, and his parents' next door neighbor. What I saw was eye-opening. The portfolio has compounded at 13.5%, a bit over 2% behind the market since inception, including S&P 500 dividends. Performance was strong, but trailed the market in 2003, and then has been in single digit territory every year since.

The client is a 26 year old who works in political consulting and political campaigning. He is very well compensated, very frugal, concerned with risk but not volatility, and an economics graduate from a great school. He has never withdrawn money from his brokerage account, and he has income producing real estate and plenty of cash to tide him over in periods when there's not a campaign on and he's not working -- in other words, almost an ideal client for a performance-oriented money manager.

So the portfolio confuses me to death. 25% of the portfolio is allocated to mutual funds. Of those, half the allocation is internal Morgan Stanley funds that have front end loads, high expense ratios, high portfolio turnover, short manager tenure, mediocre performance in bull markets, and aneurysm-inducing performance in bear markets. In other words, your basic nightmare. Implausibly, half the mutual fund allocation is in Davis New York Venture, though I suspect this was a clerical error.

60% of the portfolio is allocated to just under 20 equity and ETF positions, most of them on the higher end of the S&P 500 capitalization scale (AAPL, GOOG, BAC, etc.). Amazingly, the broker wrote covered calls on the whole thing, and most of the calls were written at strike prices just slightly above the entry price, and a year out to boot! So, the entire equity portion of the portfolio has bond-like returns without the downside protection,a situation that baffles me. It reminds of Dean Wormer in Animal House, who told Flounder that "fat drunk and stupid is no way to go through life, son."

The remainder of the portfolio (15%) is in junk bonds, all rated CCC+ or below. Looking at past statements, it's clear what the broker is doing. He's doing a simple screen of bonds with a 10% YTM and buying a few at any given time, generally focusing on companies that are household names, like Rite Aid and Six Flags. Of course, accepting CCC credit risk for a 10% YTM and 8%-9% coupons strikes me as the height of folly in a market like today's. "Yield pig" is a word I have heard; today I indirectly met one.

In aggregate, this portfolio does the client a great disservice. Here we have a young man who is perfectly situated to accept the returns and volatility of an intelligent investing program. In fact, he's almost a dream come true as clients go; he even knows what time weighted IRR means! And yet this broker has him in a portfolio that is likely to produce no more than 10% per annum, all without any credible downside protection. Aside from the 12% allocation to Davis New York Venture, the portfolio would get killed in a market downturn. Highly valued common stocks (capped by written calls, no less!), shitty mutual funds, and a bunch of CCC debt sure isn't my idea of a margin of safety.

In any case, the client is going to move a portion of his assets to me, though he can't move the entire portfolio for fear of causing unpleasantness among himself, his broker, and his parents. I am always fascinated to see things like this -- spend too much time on Liquid Lounge, or in Omaha, or at things like the Value Investing Congress -- and it's easy to lie in bed at night and ask yourself where on Earth your alpha could ever be coming from. Today, I was reminded, and I'm sure I'll sleep like a baby.

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