In my previous articles, I demonstrated the benefits of investors extending their time horizon when evaluating an investment manager’s performance because it’s almost certain that even the best managers will underperform at some point in time.

I would readily acknowledge that extending the evaluation time horizon can also lead to underperformance if investors hold on to a poor manager for too long. Investors are faced with a situation where utilizing a long time horizon is a necessary condition to outperform, but it’s not a sufficient condition to outperform because an investor may end up holding on to an underperformer too long. This article demonstrates one potential tool investors can use to avoid both firing too soon, and firing too late.

Monitoring an active fund manager
The chart shown below is known as a quality control chart. It displays a manager’s annualized cumulative value-added performance compared to the relevant benchmark through time. Quality control charts are designed to determine if the outperformance (or underperformance) delivered over time has been derived from random movement or from actual investment skill (or lack thereof).

In the case of this quality control chart, the performance pertains to the same manager’s performance track record that was examined in my previous article.

Source: Proteus Performance Management Inc.

If the returns tend to be above the top end of the confidence interval, you can reject (with a certain degree of confidence) the null hypothesis that the manager’s added value is due only to random movement, not skill. In this particular case, 5% of a random distribution lies above the top red line and 5% below the bottom red line. If the manager’s value-add performance is above the top line, there is a 5% (or less) probability that he or she was lucky rather than skilled.

The same technique can be utilized to examine an underperforming manager who falls below, or is consistently close to, the bottom red line (see below). Depending on where he or she falls, he or she may be unskilled or only unlucky.

Source: Proteus Performance Management Inc.

For performance within the red “cone,” random luck versus actual skill is more difficult to discern. You will also note that red lines tend to converge over time. The longer a track record is, the more statistically significant it becomes.

One of the benefits of this technique is that you can specify any confidence interval you wish to use (i.e., 60%, 95%, etc.). For example, a committee may say that it wants to be 80% confident that it hires managers with skill and 80% confident that it does not fire managers with skill. However, you will also note that it’s nearly impossible to be 100% sure of skill over what most investors would consider a reasonable time frame.

Hire/fire decisions impose real costs on investment programs, such as trading commissions, bid/ask spreads, taxes, market impact and the often-forgotten opportunity costs (which will often dominate the other costs). Beyond these costs, investment manager search and transitions are also time-consuming endeavours for time-strapped individuals and committees to undertake. As I’ve noted in the past, research has shown that even sophisticated institutional investors often fire managers just before their performance rebounds and hire managers that have recently outperformed, only to see negligible ex-ante outperformance. Quality control costs could be one tool to help reduce the unnecessary costs incurred by investors.

Quality control charts should form one input into manager oversight and they are not perfect. For instance, if the person or team responsible for the performance track record leaves the firm, it’ll be hard to argue that the past track record demonstrates the skill level of the new manager/team unless the firms has built truly world-class robustness into their investment process. This is why a more holistic oversight approach is required, monitoring both qualitative and quantitative aspects of the manager over time.

While not firing a skilled manager is a good starting point, it would certainly be preferable to not have hired a manager who is likely to underperform in the first place. My next article will discuss a tool investors can use to avoid the likely underperformers.

Ryan Kuruliak is a Toronto-based vice-president with Proteus, an investment and governance specialty firm. He has more than 14 years experience in the pension and investment consulting industry.

These are the views of the author and not necessarily those of Benefits Canada.

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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