Choosing a fund manager

Choosing a fund manager is one of the most important investment decisions you will ever make. Matthew de Wet, head of investments at Nedgroup Investments, says that, although there is surprisingly little research about what makes a manager successful, there are characteristics of successful fund managers you should look out for. “A good performance track record seems like the most obvious place to start,” he says.

Select fund managers who have outperformed their benchmarks over long periods, including at least one complete market cycle.

Investment behaviour experts are particularly critical of the fickleness of private investors, whose tendency to favour unit trusts with the best one-year track record is well documented.

Geoff Blount, chief executive officer of Cannon Asset Managers, says: “If you are a short-term investor, then the most likely ‘winning manager’ selection strategy is to look at recent short-term ranking tables, but to disinvest from the manager as soon as relative performance turns is clearly a strategy that is not practical.”

He says there are a number of things institutional investors can do to improve manager selection decisions and avoid nasty surprises. The first is to avoid the common mistake of relying on past performance and the brand of the asset manager — focus instead on investment philosophy, investment process and manager skill.

Empirical research confirms that past performance has absolutely no bearing on future performance. An investor should rather use fund manager performance to assess whether the manager is implementing their philosophy and process in accordance with their stated intentions. A closer analysis of published returns will also confirm whether the asset manager achieved the performance on the basis of skill or luck.

“In asset allocation funds … asset managers are usually measured against each other,” says Karl Leinberger, chief investment officer at Coronation Fund Managers. Institutional investors use the Alexander Forbes Asset Consultants’ Global Manager Watch (Large) report to size up the opposition. The report ranks South Africa’s 11 largest asset managers (with balanced portfolio funds that comply with Regulation 28 of the Pension Funds Act) based on gross annual returns.

In May 2010 the top five-year performers include Investec Asset Management, Alan Gray, Foord Asset Management, Coronation and RE:CM. The report comes with a few disclaimers, most notably that performance should not be judged over a short period of time and that past performance is not a guide to future performance. Looking at performances at a “point in time” is particularly risky because long-term performance can be skewed.

Blount says: “A manager who has recently shot the lights out will have good one, two, three and possibly five-year numbers, but this is not reflective of their true long-term poor performance. Conversely, a good manager who has struggled recently will have poor long-term numbers, looking back from today.”

A trustee responsible for pension fund or other institutional investments should look first for a fund manager that consistently applies its investment philosophy and process, and then look for one that shows superior performance.

A recent Canadian Investment Review study considered hundreds of different investment managers in different regions over a six-year period. The study identified four out of 17 factors as significant in explaining fund manager performance.

The first is ownership. Investment management firms with a high degree of employee ownership tend to produce superior results to those that have little or no employee ownership.

“This is intuitive,” says De Wet, “as the greater the degree of ownership, the greater the incentive for employees to produce good performance.”

South Africa’s top fund managers know this. Old Mutual Asset Managers led the way in the first quarter of 2007 when it transformed itself into the multi-boutique investment group, Old Mutual Investment Group SA.

Asset manager performance also hinges on low staff turnover. Firms with a high degree of turnover in terms of key investment staff produce inferior results when compared with those with low turnover. The study also concluded that staff retention was closely correlated to ownership.

Another critical characteristic for asset manager performance is focus. Investment managers perform better when there are fewer shares in the portfolio. Excessive diversification restricts a fund managers’ ability to outperform the market. De Wet says: “This makes investment sense because the more shares held, the lower the tracking error and the higher the likelihood of producing average returns.”

The fourth success factor is a “bottom-up” investment process. Fund and investment managers produce superior results by stock picking. “It is interesting to note that the first three factors are more closely aligned with entrepreneurial or ’boutique’ type investment firms than they are with larger firms,” says De Wet. Smaller fund managers tend to have a higher degree of employee ownership, lower key staff turnover and streamlined portfolios.

Private investors should benefit from sticking with niche fund managers. “Potential investors may be best served by identifying smaller, owner-managed investment firms with low staff turnover, whose process is one of active ‘bottom-up’ stock picking,” De Wet says. Although this approach should work well for institutional investors, they will have to consider the asset manager size during the decision process.

This article first appeared in the Mail & Guardian

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