The risk of selecting the incorrect investment manager

How costly is poor manager selection to your portfolio returns? You might have got away with it over the past five years, but going forward, it is likely to be increasingly important.

One of the hallmarks of a bull market is the opportunity it provides for most asset managers to deliver good absolute returns for investors. The South African All Share Index has compounded at over 20% per annum over the past five years. Most managers, and investors, even if they got their strategy slightly wrong, would have achieved decent returns over such a period.

The right selection for the environment

As multi-managers, we are very aware of the importance of selecting the appropriate managers in an environment where the South African All Share Index could very well deliver pedestrian returns. Investors should construct their portfolios based on more than just what has worked well in the recent past in order to continue to do well in the future.

Equally important, investors that backed last year’s winning strategy would also have done well, as the markets re-rated strongly on the back of low interest rates and quantitative easing.

It will be much more difficult to generate decent returns in an environment where equity markets do poorly, even if the manager gets their underlying strategy correct. Equity valuations look increasingly stretched, the economy is weak and short-term interest rates are likely to increase further. In such an environment, it is important to construct portfolios that can offer some downside protection and find managers that can still generate inflation-beating returns.

Lean towards a multi manager

One way to account for these uncertainties is to invest with a multi-manager. Simply stated, a multi-manager is an asset manager that invests in other asset managers. Multi-managers do not try to time the market or select the asset manager that will perform best in the short term. Instead, they build portfolios that will be fine in most market conditions. For a multi-manager the critical question is how to construct solid, diversified portfolios with as many independent sources of returns as possible.

The reality is that the best asset manager at one point in time will not be the best manager all of the time. There are certain environments where one type of manager will flourish, and others that favour managers with a different investment style.

Managers that have done especially well in the recent bull market are unlikely to be appropriately positioned should the market de-rate. Similarly, asset classes that have done particularly well in a falling interest rate environment are unlikely to repeat their performance should interest rates increase.

If you try to time the market, you are possibly building undiversified portfolios that take big bets on one outcome materialising. Unfortunately, you will invariably take on inappropriate levels of risk: either too much at the top of a bull market when you are too optimistic; or too little near the bottom of a bear market when you are too pessimistic.

Recent performances

The same applies to asset manager selections. Basing your selection on recent manager performance is likely to lead to disappointment. Standard & Poor, an international research organisation, has shown in its most recent Persistence Scorecard, which tracks how consistently unit trusts in the USA rank as top performers, that less than 10% of the unit trusts classified as top-tier performers in September 2011 retained this standing in September 2013.

Multi-managed portfolios are not just constructed for the good or bad times, or for what multi-managers think the next 12 months will be like. Instead, they look to find as many uncorrelated sources of return as possible in the belief that there is a much greater chance of success in getting this right than in trying to accurately forecast what will happen next week, or next month, or next year.