Volatile markets highlight importance of selecting the right fund manager

The recent volatility in local and global stock markets has highlighted the importance for investors to follow a more robust selection process when deciding on which funds to invest their hard earned savings in.

According to Linda Eedes, Senior Analyst at RE:CM, a value based asset manager, selecting an asset manager based on performance alone is dangerous as investors are not able to determine whether the good performance is due to skill or luck.

This is exacerbated by the fact that most people tend to evaluate asset managers over inappropriate time periods, which can lead to investing or disinvesting at precisely the wrong time. “Too many people tend to invest in funds that are performing well, without considering the processes these funds are following and the risks they are taking to generate these returns.”

She says that empirical research shows that chasing performance does not work. “The likelihood that a general equity fund which was in the top 10% of the universe this year will be in the top 10% next year is only 4%.

Eedes says that most investors regard three years as an acceptable period of time to evaluate performance, yet five of the top ten performing general equity funds for the four years ending May 2008 - the peak of the market - have been the worst performers since then. Conversely, the worst performing general equity fund for the four years to the peak of the market in 2008, has been the top performing fund since then. “Unfortunately, it is only when funds start to underperform that most investors start to question whether the fund manager they have chosen is able to protect their savings against a downturn in the markets.

“How asset managers protect capital in a downturn market has a very significant effect on long-term performance and should not be ignored. Over the long-term, the winner is not the investor who makes the most when the markets go up, it’s the investor that loses the least when the markets go down.”

She says that when evaluating funds, investors need be sure to pick a time period that includes both a bear market as well as a bull market – peak to peak or trough to trough.

Eedes adds that instead of focusing mainly on performance, it is important to assess asset managers based on their investment processes. “A good process will ultimately lead to good results in the long term and importantly, is repeatable from one market environment to another.”

Eedes says that investors should look for the following attributes when deciding on a fund and a fund manager:

· A fund manager who has an investment approach that can be explained in simple language:

Investors should ensure that their fund managers can explain their investment approaches in simple English. Staying with a manager through the full market cycle requires trust on behalf of the investor, especially through periods of short-term underperformance. This trust is very difficult to build if the investor doesn’t fully understand how the manager is investing their capital.

· A manager with a robust investment process:

Investors need to realise that performance is merely an outcome when it comes to investing. A stable, disciplined process, applied consistently, will inform the investor if there was skill in delivering positive returns, and importantly, whether it’s repeatable.

· A manager with a long-term orientation:

Many managers claim to have a long-term orientation, but an easy way to confirm this is through relatively low portfolio turnover. For instance, if the annual turnover of the fund is 20%, this suggests that the entire portfolio is turned over every 5 years, a good proxy for the manager’s investment horizon.

· A manager that follows a distinctive philosophy:

Successful fund managers should follow a distinctive investment philosophy. Crucially, they should be able to demonstrate that they have applied this philosophy consistently over time, rather than changing horse midway through the race.

· A manager who invests alongside their clients:

Fund managers should commit their own capital alongside their client’s capital. When the markets fall, managers who are invested in their own funds are less likely to cut their losses in order to protect their careers, rather than make the right decision.

· A fund with a track record:

When assessing an asset manager, investors should measure past performance over a full market cycle, preferably from peak to peak and trough to trough. Evaluating a manager on performance generated in one type of market environment only is likely to lead to disappointment.