How to choose a fund manager

Geoff Blount, CEO of Cannon Asset Managers, suggests ways for investors to improve manager selection decisions and avoid nasty surprises

When choosing a fund manager, we believe 70% of the trustee’s decision is based on two factors which have no bearing on a fund’s future performance: past performance and the brand of the asset manager. Investment philosophy, investment process and manager skill have a much lower weight in the cognitive process they apply in manager selection, either concisely or subconsciously, yet these are the factors that should be under consideration.

Figure 1: Typical factors and the importance ascribed to them by investors in fund manager selection

Figure 2: More appropriate factors and their importance in fund manager selection

Trustees may find the comment that past performance has no bearing on future performance contentious, but this is supported by both empirical evidence and academic research.

This assumed relationship is a classic case of the post hoc ergo propter hoc fallacy (after this, therefore because of this). Trustees may think that because a fund shows good performance, it will continue to do so. It is, however, the quality of a manager, their philosophy and process that is the link between past and future performance, and not the performance itself.

The fund manager’s performance should rather be used as a base for understanding if the manager is implementing their philosophy and process in accordance with their stated intentions or not. Analysing the numbers should allow trustees to confirm whether the asset manager has achieved the performance on the basis of skill or luck. Skill is repeatable, luck is spurious. Unfortunately, many trustees do not have direct access to the asset manager and are thus not in an ideal position for making such decisions.

Figure 3: Manager quality, not past performance, drives past and future performance

Our research indicates that the only connection between past and future performance is that of short term momentum: recent good performance is likely to continue into the near future. This stands to reason, as a portfolio consists of shares that have momentum, and the portfolio will exhibit the aggregated momentum of the underlying shares, best measured over 6 to 12 months. However, the momentum decays over the following 3 to 12 months, depending on state of the market. This implies that if you are a short term investor, then the most likely winning manager selection strategy is to look at recent short-term ranking tables but to disinvest from the manager as soon as relative performance turns, clearly a strategy that is not practical.

Another key risk of using past performance at a “point in time” is that even quality managers have cyclical alpha. That means that if you don’t look at the long-term rolling average alpha numbers, a manager who has recently shot the lights out will have good one, two, three and possibly five-year numbers, but this is reflective of their true long-term poor performance, i.e. discrete measurement periods may not show long-term average negative alpha. Conversely, a good manager who has struggled recently will have poor long-term numbers, looking back from today. Rolling average alpha analysis will unmask a much more relevant performance series that may demonstrate skill.

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Figure 4 shows a quality manager that over the long term beats their benchmarks by 5% p.a. However, using a “point in time” to measure discreet historical performance periods can create the wrong picture of the performance. If the end point in time is high, long term performance is overstated, and a low point end time will understate long term performance. This will be exacerbated by the starting point of measurement as well.

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Figure 5 demonstrate how even a poor performing manager that underperforms their benchmark over time can be made to look good if the end point in time is a “High Point”.

A trustee should also look at the extent to which managers deviate from their stated objectives. In other words, does the manager’s shape of performance match what they set out to achieve or what you expect them to achieve? If a value manager performs well in growth style markets, you have a problem. If the manager is doing exactly what he set out to do, then the investor is getting the type of fund that he has chosen and the performance that has been achieved is a result of manager skill rather than luck.

Luck can work in both directions: by selecting a manager based on his investment skill, an investor is less likely to be exposed to nasty surprises.

This is of particular importance if a pension fund chooses to blend different styles and different philosophies. You want to know that you will get the type of fund performance and attributes that you have chosen. A trustee needs to look first for a fund manager which is consistently applying its investment philosophy and process and then to look for one that shows superior performance traits.