In these challenging economic times it is essential to have skilled active fund managers but they are tricky to identify. Michael Klimes looks at how to find them.
- Research suggests there needs to be 12-25 years of data to spot good managers
- Much of the time this data is not available
- Trustees and advisers have options but they require a lot of work
For years academics have debated whether active fund managers are lucky or skilful and what the most effective ways are to distinguish between them. The only point on which they seem to agree is past investment performance cannot be a clear indication of future returns.
If it is true that some fund managers can beat the market and the past is no reliable guide, then it is crucial to separate talented managers from fortunate ones. This is urgent given the challenging economic times investors are experiencing.
A paper published by Columbia Threadneedle in June 2015 argues active fund management can help schemes generate better returns on its investments. Not all active managers are created equal – what to look for and why was written by the firm's head of investments and pensions education Chris Wagstaff (pictured above), who is also senior visiting fellow in the Finance Faculty of Cass Business School.
Wagstaff is convinced a brilliant manager can beat closet tracker funds, which manage their portfolios on an almost passive basis while charging active fees. This is especially important in an environment where yields are so low and market behaviour so uncertain.
These factors complicate life for trustees. "In the short run it is very hard to say whether outperformance is skill or luck," Wagstaff says. "Unless you have between 12 to 25 years' worth of data it is very difficult if not impossible to say this fund manager was lucky. That does not put us in particularly good light."
Apart from the lack of accurate, good-quality monthly data that a scheme requires in order to properly assess managers, there are other problems as well. "I have spoken to academics for many years and to be perfectly honest nobody has reached any consensus [on the minimum amount of data collection on fund managers]. I think you need 20 years of monthly data to prove skill over luck yet it is so much easier to get the data on the fund rather than the fund manager data."
But, while Wagstaff explains skill can take some time to prove statistically, he says evaluating fund managers against key qualitative performance drivers that point to the ability to outperform over time is "time well spent" - and lists a number of key factors that could be indicative of a manager that will outperform (see box below).
Willis Towers Watson head of equities Stephen Miles acknowledges the predicament facing trustees and their advisers, but he believes there are ways to cope. However, he cautions that a tremendous amount of work is needed from them.
"It is a complicated world. We try to reduce information asymmetry between buyer and seller when picking active managers," he says. "If you are a trustee and from outside the industry, to be frank it is a tall order [to pick a good manager]. Trustees and/or their advisers need to spend a lot of time on this. It is a challenging endeavour but a very rewarding one if done well."
Any selection of a manager has three phases: the initial contact with the headline performance, understanding the investment process of that particular manager and the individual decisions he makes.
Miles explains: "You have to get under the skin and beyond the headline performance – which is partly due to skill and partly due to luck. To pick a good fund manager, dig deeper into the investment process and the rationale for individual decisions or actual investments. The quality of individual decisions is the foundation of the investment strategy and the performance."
He adds: "We spend over a hundred hours appraising a single investment strategy. We have a devil's advocate policy where a minimum of two people assess an investment strategy."
Nevertheless he warns: "If you are an outsider it is easy to be impressed by someone in our industry as most portfolio managers are intelligent and confident specialists in their fields."
Stamford Associates investment director and head of investment manager research Nick Wyld agrees there is a large amount of work. "Academic research such as this should come with a financial health warning – the past is no reliable guide to the future. In our experience, the best way to differentiate between luck and skill is to assess a manager's actions – to painstakingly analyse and understand the portfolio investment footprints."
However, some are sceptical the hurdles can be overcome, such as Cass Business School professor David Blake.
He is downbeat about the ability of trustees and their advisers to vet managers. He draws on a notable paper called Picking Winners? Investment Consultants' Recommendations of Fund Managers, written in 2013 by Tim Jenkinson, Howard Jones and Jose Vicente Martinez of the Saïd Business School at University of Oxford.
It looked at equities and examined 13 years of survey data. The authors concluded that consultants' advice to US plan sponsors on fund selection did not improve returns. The research showed the average returns from recommended funds were 7.13% but non-recommended funds provided 8.13%.
Blake says: "It is a folly to think trustees, who don't have the skills, can do this with wise guy consultants telling them that they can do it [pick good managers]."
There are four obstacles that prevent trustees and their advisers from finding a talented manager. First, Blake believes very skilled fund managers like Warren Buffet are really in the retail sector rather than the institutional sector. Second, he argues consultants earn too much money from a product offered to clients that cannot deliver. Third, if there are multiple managers in the same fund, how do can you accurately report on their individual performance?
Finally, if a scheme finds a great manager who invests in a particular asset and all the other skilled managers pile in, that just "puts price pressure on those investments in the wrong direction and reduces returns," he continues.
With Blake taking the opposite view to many and even arguing there is a shortage of talented fund managers in the institutional investment space, it is clear this debate is far from over.
Although no one factor or quality gives a genuinely skilful manager an edge, Columbia Threadneedle believes the key issues to consider when selecting an active manager include:
- Adherence to a proven and repeatable investment philosophy and process that captures the manager’s investment insights and value adding processes; an investment approach underpinned by a culture that is dynamic and interactive and by processes that are team-based, performance driven and risk aware
- Application of the three Cs – high conviction portfolio positions, contrarian/independent thinking and high portfolio concentration
- Employing an 'investing to win' mindset, typically evidenced by a high active share and tracking error
- Dedication either to a single investment style in which success has been demonstrated, given that each investment style demands a different mind and skill set, or to a stock picking approach which has successfully emphasised particular style traits consistent with the investment outcomes targeted; a patient investment approach – given that this benefits from the greater predictability of asset prices over the longer term; a strong sell discipline – with sale proceeds being invested in new portfolio ideas rather than being spread amongst existing ideas; and a considered approach to portfolio turnover, given the potentially adverse effects of high transaction costs on fund performance
- The incorporation of Environmental, Social and Governance (ESG) considerations into the investment process that promotes best practice in corporate governance and sustainable and responsible business and management practices, as ESG factors become increasingly material to company valuations
- Appropriate manager and team remuneration structures that align interests with the end investor
- An ability to
- Combine proprietary macro and micro insights into investment decision making
- Clearly articulate how ideas find their way into their portfolio
- Be open to debate and genuine challenge
- Recognise and control their behavioural biases, particularly groupthink, misplaced confidence and an aversion to realising loss making portfolio positions
- Recognise the capacity constraints of their chosen strategy
- Add value in both rising and falling markets, particularly the latter
- Put risk management at the centre of all that they do
Although Columbia Threadneedle said the evidence was sketchy, it also found female fund managers appeared to produce more consistent and less volatile performance than their male counterparts.
It said research suggests that once a skilful manager has been identified, a patient approach by the end investor must be adopted for skill to shine through – noting that all too often investors treat periods of poor performance as proof of skill having deteriorated and explaining that even the most skilful of managers will periodically underperform
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