FINANCIAL markets are risky: we don’t know what returns they are going to deliver. That means we can sometimes earn great returns just by luck, but for the same reason incur big losses too. The same applies to fund managers, both individuals and institutions. So determining the best fund managers requires seeing through the randomness to understand who really is doing a good job.
Sceptics argue that randomness is all there is to the investment story. There’s no end of examples of stock-picking competitions that have been won by a four-year-old or a random number generator. The author Nassim Taleb even argues that Warren Buffett, whom many consider the best investor of all time, might achieve his returns from luck rather than skill.
Taleb points out that if manager returns are random, and there are enough managers out there, one of them is going to be a massive performer by definition.
If Taleb is right there would be no point in investing through active managers at all. Not one of them would be systematically better at their jobs than any other, so you’d be best off investing in passive vehicles that blindly follow the market. The problem is, if everyone did that, there’d be no price discovery at all and prices wouldn’t move despite obvious changes in the fundamental earnings of companies. (Not to mention other problems such as the lack of oversight of management or the tracking error incurred by such tracker funds.)
That would make the returns to active management much more obvious but the challenge would remain to pick which ones to back and how to test them.
“I agree that short-term performance says nothing about the manager,” says Thabo Khojane, MD at Investec Asset Management, “but over the long term — by which I mean a full cycle, so somewhere between six and 10 years — that says a lot about the manager.” The problem is that if you are just going to judge managers on long-term performance, there aren’t many around who have accumulated that vintage. “That is the first reason why manager selection is so incredibly difficult,” he says. “Just not enough managers have the seven-year track record.”
To see the problem more clearly, imagine assessing a chess player. You would be able to watch their moves and form a view pretty quickly about how capable they were after a game or two. On the other hand, watching a roulette player isn’t going to give you much information on their capabilities after a few spins of the wheel.
Fund managers are somewhere in between in terms of how random probability clouds the assessment of genuine skill.
Allan Gray chief investment officer Ian Liddle says it’s like trying to assess a poker player after only five hands.
“Would you rather see who has won the most after five rounds or would you rather stand behind their shoulders and see how they play over five rounds?” he asks.
“What you really want to do is watch over the shoulders of the asset managers to check their process — is it disciplined and does it stick to a philosophy that makes sense?”
Khojane says that’s particularly important during times of stress. “When [a manager’s] performance is bad their stock picks look wrong and everyone is saying they have lost their minds. You have to observe them in that period to know if you want to back them in the long run. If they start changing things for reasons that are not clear then they are not the type to back,” he says.
Nedgroup Investments, which operates an unusual model in allocating its assets to third-party managers, knows a lot about assessing them. Its head of investments, Matthew de Wet, says many fund managers go through the same material and the challenge is to focus on the 0.5% that distinguishes them from the rest. “There’s no recipe you can use to determine just who is good and bad. There are a whole lot of small things that create a mosaic. If I went into a meeting and the manager didn’t have any slides and just started speaking about what he’s doing and why he’s doing it, that’s better than someone with 100 slides and a lot of detail.
“You really want the managers to understand the essence of what they are doing and articulate easily what their competitive advantages are and why those are sustainable. If you narrow your focus down to that you are off to a good start and surprisingly few can do that.”
Studying the published fund fact sheets and regular performance reports is a good way investors can get access to fund managers’ ideas without literally having to sit at their shoulders. “You really actually need to understand the structure of the business and the nature of the business you are dealing with to make an assessment of whether that historical performance is going to be repeatable,” says De Wet.
Liddle says that public presentations are also a good way to assess managers. “We really put ourselves out there for people to quiz us and interrogate us and ask us the hard questions about our portfolios and strategies,” he says.
It follows that a manager who is unwilling to provide that level of transparency is probably one to avoid.
IM's five Ps for assessing investment managers
But what is it you want to establish through such interrogations? Below are Investors Monthly’s five “Ps” of assessing investment managers.
PROCESS
How does the investment manager make decisions? Are they properly researched? Does the manager actually study the investments he or she is considering? Are the decisions made through a challenging process that discourages groupthink and brings out the best of the people at a firm? Does the process properly deliver on the investment philosophy of the house in a robust way that can handle all phases of the cycle and remain consistent over time? Is the process institutionalised and sustainable or does it depend on one or two key personalities?
PHILOSOPHY
What is the house’s view on how to consistently deliver returns for its clients? Does that philosophy make sense and is it clearly articulated by the house? Also consider whether the philosophy gels with your own investment objectives.
For instance, if you are averse to risk you may want to avoid an activist investor who buys into distressed companies.
PEOPLE
You want to ensure that the people you entrust your money to are qualified and experienced, but you also want to assess their thinking and decision making, ensuring those qualifications and experience translate into good investment decision making. To do that you need to look at the judgments those individuals have made. Many have presentations and media interviews available online, as well as their market and performance commentary pieces.
Go back and look at whether they made the right calls in the past. But while people are important, you also want to ensure that the institution is robust, so a key question to ask is whether it is able to attract the right people consistently. People will move on and your investments won’t.
PRICE
Over time performance can easily be eaten up by fees charged but, on the other hand, paying for a good manager can be far cheaper than being saddled with an underperforming cheap manager.
The key thing is to understand what fees you are being charged and include that as part of your overall judgment.
A good thing to look for is the “total expense ratio”, which captures all the costs as a percentage of the assets in the fund. A manager that does well on all the other Ps might be worth paying more for.
PERFORMANCE
Finally, it all comes down to performance. If the other Ps are right, performance should be the natural result. And it is critical to look at performance through a long-term lens.
Different points of the cycle may suit different managers and it’s easy to be swayed by the luck of a manager in the short term, rather than their skills over the long term. Performance figures should be studied on a five to 10-year view.