Historically pension funds and other investors have tended to select investment managers based on their recent investment performance. This can lead to a pension fund consistently firing yesterday’s losers and hiring yesterday’s winners. By chasing past performance these investors are effectively buying portfolios at high asset values and selling portfolios at low asset values, a recipe for long-term failure.
Here are five areas to consider when hiring (or firing) an investment manager:
Past performance cannot be ignored. However, it should not be the only factor considered. At the same time is important to put past performance into context. For example, the last several years have been difficult years for global managers employing a value style, as a result of the strong performance of a number of technology stocks, such as Amazon, Alphabet, Facebook, Netflix, Tesla, Alibaba, etc. Value managers have avoided these market darlings, due to how expensive they continue to be. Comparing a manager to a style-based index, would help to provide some context. Similarly, you could compare the manager in question to other value managers, to better assess their performance.
This factor involves an assessment of the stability of the investment team and the organization. A team that has trouble retaining its analysts will have a difficult time replicating its past success. It will spend time recruiting and training new team members. But more importantly, if a number of analysts leave, the performance of the strong stock selection in the sectors that they cover may be walking out of the door with them. This applies even more where the lead portfolio manager leaves the firm. However, stability extends beyond the investment team to the entire organization. The ownership structure can have a big impact on the performance of the investment teams. For example, privately-owned firms, with shrinking asset bases, are seeing the value of their investment in the firm shrink. Similarly, when investment firms are being marketed or have been sold, investment professionals may be focusing on the impact of organizational changes on them, and their place in a new organizational structure, at the expenses of their portfolios. For this reason, plan sponsors should be following personnel turnover and organization changes impacting their portfolio managers.
Strong performance is great, but it is important to assess how much risk the manager is assuming to deliver that performance. If a manager is the top performing manager in their universe but only holds one stock in their portfolio, a pension plan is assuming a lot of risk to achieve that performance. There are different ways to assess risk, using different risk measures, such as standard deviation, sharpe ratio, tracking error, information ratio, upmarket capture and downmarket capture. However, it is important not to evaluate these things blindly. The risk measure used must be consistent with the manager’s stated style and results should also be consistent with the approach. For example, if the manager runs a concentrated strategy with a strong style tilt, a higher tracking error should be expected. Similarly, there would be less of a focus on information ratio, as the manager will tend to generate a high tracking error.
This is the hardest to capture, but is a critical element of assessing a portfolio manager. It involves answering these key questions:
– Is the portfolio consistent with the stated style?
– Are the sector weights reasonable?
– Are the stocks or bond holdings consistent with the stated style?
– Where are they generating the value added/lost?
In essence, this involves assessing whether the manager is building a portfolio consistent with its stated style. This is a key determinant of whether the manager’s portfolio can be expected to replicate its past performance. The best way to assess this is to look at the stocks or bonds held by the manager and determine whether they are consistent with their stated style and approach. This part of the assessment is more of an art then a science, but it is none-the-less critical.
A question often asked by an investment committee in a search is how important of a factor should fees be. The answer depends on the efficiency of the asset class and the magnitude of the fee differential. In asset classes, such as Canadian bonds, where the value-added achieved by the best managers is small, a significant fee savings is likely to have a significant positive impact on after fee performance. In contrast for emerging markets equity, which is a more inefficient market, where the value added of a top manager can be more than three per cent, a small difference in fees should not have a big impact on the decisions.
Overall, taking a structured approach to evaluating portfolio managers, by assessing these five factors, will provide a deeper understanding of your investment managers and their strategies and are prudent considerations when looking to hire or fire managers.