Team selection – picking a good fund manager
With superior portfolio construction methods, more diversified portfolios and efficient trading practices, skilled active managers can reduce potential capital losses and generate returns in excess of market indices. But the opposite can also occur – a manager or a fund can significantly underperform its peers and the market. How then does one ensure that the team you’ve selected to manage your assets will stand up to the test of time, and when should you fire your fund manager?
The 3 P’s (Philosophy, Process and People) are often quoted as the main determinants of an investment management firm’s success. A 4th P (Pay) can provide significant motivation for fund managers to perform better than peers over long periods of time, while an analysis of the last ‘P’ (Performance) can often lead investors astray. We will discuss these 5 P’s in more detail:
Philosophy refers to the beliefs and culture of the organisation – these sets of beliefs will guide investment decisions and investors must ensure that they share the same investment beliefs. A philosophy alone will not make or break a firm, but it is nevertheless important for clients to at least agree with the principles that the fund manager applies.
While the philosophy of a firm outlines what they are trying to achieve, the process refers to how the philosophy is implemented. A firm’s process governs such things as trading practices, buying and selling decisions, risk management techniques, investment constraints and portfolio construction techniques. One can’t argue that one process is better than another, but a firm lacking a robust, repeatable process does not have the checks and controls in place to ensure that the philosophy is implemented consistently. In a steady bull market when most funds perform well, a lack of a defined process is seldom scrutinised as a rising tide floats all ships. However, as Warren Buffett puts it, “you only find out who is swimming naked when the tide goes out”. A lack of a repeatable, robust investment process means that fund managers are more likely to stray from their comfort zone when making investment decisions during difficult times. For example, switching from a value style (buying companies below intrinsic value) to a momentum style (buying in anticipation of short term earnings upgrades) when a bull market approaches maturity not only exposes investors to unnecessary risk, but changes the very nature of the fund.
Now that we know what asset managers try to achieve as well as how they try to achieve it, it is important to determine who is responsible for implementing decisions and growing investor’s wealth – the people of the organisation.
From a boutique firm with five employees to a large multi-national money-managing machine, the people make the decisions. As investors, we need to know who these people are. Where do they come from? What qualifications do they have? Do they have any support? And what other responsibilities do they have? It is vitally important to understand how decisions are made within a team – does the manager have full autonomy, or is it a team-based approach? While one approach may not necessarily be better than another, the implementation of decisions can play a role in the success of the fund. A team-based approach ensures that there is continuity even if one or more portfolio managers leave. A small firm following a single manager approach may struggle to fill the void left by a star manager – and could lose assets as a result. On the other hand, the loss of a fund manager does not always have a detrimental effect on fund performance as he/she may be replaced by a more highly-skilled manager.
Investors must be aware that small firms (especially newly-established firms) will always have fewer resources than a larger organisation and fund managers may need to devote a significant amount of their time to building a client base (by attending road-shows and client presentations). Investment decisions and research could, by necessity, become secondary to gathering assets. In mitigation though, smaller firms often use research from brokerage houses, especially for large cap stocks with good analyst coverage, while technology can provide fund managers with up-to-date portfolio information remotely. A smaller firm size can also result in quicker investment decisions (less paperwork) while a smaller fund size allows for more investment opportunities, especially in the small/mid cap space. Another concern for some investors is that fund managers responsible for a number of different funds may devote more time to their ‘favourites’ to the detriment of others. This could be problematic if the funds have varying mandates and/or investment styles. However, an equity fund manager responsible for the firm’s balanced fund does not necessarily need to do twice the research, as the stocks held in the balanced funds are often the same as, or similar to, those held in the equity funds and economic research is already part of the company analysis process.
Once you are comfortable with the firm’s philosophy and processes and decided that the people are up to the task of managing your money, it is important to ensure that these key investment decision makers are incentivised appropriately. Pay (the 4th ‘P’) becomes an important variable in selecting managers and applies to both the fund and the manager. Performance fees are purported to align the manager’s interest with the investor’s – the theory is if the fund succeeds, the manager succeeds. However, the performance fees in a large organisation benefit the shareholders, not the fund manager (unless he is also a shareholder). Investors must ensure that the potential fees payable are realistic in all market environments – one should not pay exorbitant fees in a bull market only to see returns eroded in a subsequent correction.
The manner in which the fund manager is remunerated is perhaps more important in selecting a fund than the performance fees charged. There are a number of different ways to pay fund managers and incentivise them to perform well and to remain with the firm. Ownership of company stock probably provides the best incentive to perform well – if a fund performs well it attracts investors, which increase the fund management fee income to the firm (irrespective of whether a performance fee or a flat fee is charged). This works best when fund performance affects company performance directly, as in pure asset management companies. The efficacy of stock options to incentivise remains controversial as they have an asymmetric payoff profile and are linked more to company performance than fund performance. A fund manager in a large organisation may have little impact on company profits and could benefit from stock options regardless of his particular fund’s performance. At some firms, fund managers are required to invest parts of their bonus/pension/salary into funds that they manage. These strategies could provide some incentive for the fund manager to perform well, but only if a significant portion of his wealth is tied up in his funds. Morningstar suggests investing an amount greater than the fund manager’s annual salary as a guideline, but fund managers counter that the risk profile of funds they manage do not always align with their risk profile, making an investment into the fund inappropriate.
The last ‘P’, Performance, is often mistakenly used as the first step in choosing a fund manager. An analysis of fund returns can create an illusion of thorough research, but without an understanding of the philosophy, process and people responsible for the performance one will rarely gain any insight into the real picture. The first step in analysing returns should be to determine who was responsible for the returns. A good track record becomes meaningless if the fund manager responsible for generating those returns is working at another firm! Poor fund returns can often be attributed to high fund manager turnover – in fact, the five worst performing equity funds over ten years had an average of five managers for the period, while the top-performing five equity funds had far more consistent management.
Secondly, investors should determine how the manager performed through different cycles (e.g. bull vs. bear markets) and whether returns came from stock selection or sector allocation. Rolling returns (and volatility) can be particularly useful in determining the consistency of returns and risk over time. It has been proven that outperformance over the longer term is due primarily to the prudent protection of capital during market downturns. As most of this information (except perhaps returns attribution) is available from public sources, investors can easily arm themselves with sufficient research to make informed investment decisions.
Now that we know how to pick a good fund manager, what should be done if a manager loses form? At what point do we fire the manager?
As a general rule, three consecutive years of underperformance should be a clear warning sign that things are not well. Not only does consistent underperformance put financial and reputational pressure on the fund manager, pressure from stakeholders within a large firm can add further stress. This pressure could force the fund manager to change his investment focus (e.g. from value stocks to momentum plays) in an attempt to make up for the relative underperformance. It is imperative to understand the reason/s for underperformance and engage with the manager (or at least read his investment commentary) to determine his course of action. A manager that has the conviction to stick to his philosophy through tough times should be rewarded with continued support as long as the investor remains comfortable with the approach (as mentioned above). A manager leaving a fund is another warning sign and swift action may be necessary. The incumbent manager should be taken into account when deciding to switch funds – after all, it is important to follow a manager, not a fund. Should the new manager be familiar (and have a notable track record managing similar mandates), a switch to another fund is not always necessary.
Using these guidelines to select a fund manager and having a disciplined, practical approach to investing will give one the best chance of reaching one’s financial goals.
