Posner Fights Blandness at Legg Mason Partners

There's an interesting division among active equity managers these days. One group focuses closely on a fund's index and assigns a tracking error to each fund. Tracking error is a way of measuring how closely a fund's returns follow those of an index. Brian Posner belongs to the camp that says, "Let the managers be managers." This group wants to get the latest in risk measurement so that portfolio managers have a good handle on what their bets are, but doesn't want to force the managers to follow a strict edict. The thinking here is that managers should focus on stock selection and not worry about what's in the index.

I recently talked with Posner about his vision for Legg Mason Partners funds, formerly known as Smith Barney funds. Posner's career has now come full circle: He started with Fidelity, bolted for Warburg Pincus, then set up a hedge fund, and now finds himself back in the mutual fund business.

So, just how do you manage active managers?

First, you have to articulate a goal. The goal is investment excellence and that means superior performance. Within the constraints of the prospectus and strategy, the manager must aim to perform and produce positive returns, as opposed to starting with the index as a base and asking what can I do at the margins to add value? The mindset has to be a mindset of making money.

How do you evaluate managers?

I define us as investors as opposed to traders. This definition is supported by the mentality of our managers and the turnover data. Investors should look at performance over the one- and three-year periods. You want to look at one-year returns to see if the manager is responding to changes in the environment. More importantly, a three-year time frame is a good way to assess whether a manager is doing a good job.

What's wrong with tracking error?

The great thing about this business is that you can calculate anything. But it's also a bad thing. Statistics are too often viewed as the answer rather than a piece of the puzzle that can help you to understand the goal. Tracking error is one of the more-abused measures because it has little bearing on the real risk in a portfolio. You need to balance statistics with subjective understanding. You need to look at the portfolio construction and the manager's comfort level with the holdings.

How do you evaluate a fund's risk?

I look at a bunch of things. I like to look at the actual volatility, the value at risk, and tracking error, too. But the key is how have those things changed compared with past points in time. Are they consistent with what the manager wanted to do? A portfolio should have a bias. The key is making sure the bias is deliberate. The unintended biases are where trouble can lurk.

Are you trying to bring the old Salomon and Smith Barney groups together?

We've accomplished a tremendous amount since I started on December 1 in terms of leveraging the intellectual capital and operating as a single company. The differences between the old groups are becoming less important. The key is a culture that recognizes our value is in our talent. We've opened up the dialog in such a way that analysts are now more engaged with other fund managers. For example, we put into place a technology platform that captures all of our internal research. All the investment professionals have access to it. We have a weekly action-oriented meeting that all attend.

How do you align manager incentives with shareholders' interests?

We're studying that right now. Those are changes that are coming. The changes will be on the margin. It's making sure that compensation is aligned with the underlying performance of the portfolios consistent with relevant measurement periods. We want to move to a partnership-like culture so that the success of the individual isn't solely a function of their job but also a contribution to the overall enterprise.

What underlying characteristics do you want across all of the funds?

Underlying every single portfolio is the notion that primary research-driven fundamental analysis is the key to success. All the managers here started as analysts. I don't want one single approach, but I do want primary, fundamental, research-driven analysis underlying the funds.

How have things changed since the merger?

I am very pleased with how much has been accomplished internally and the support I've received across the company, particularly from senior managers. I've sensed a rejuvenation of sorts as people realize it is different being a part of an organization whose sole focus is asset management. We played a role in getting  Novartis (NVS) to increase its bid for Chiron. Richie Freeman (of  Legg Mason Partners Aggressive Growth (SHRAX)) wasn't comfortable with the price. We filed a 13D stating that intention. That's something that would never have happened under the old organization because of the broader implications. We were able to negotiate a better price for all shareholders.