Step 4 – Selecting the People and Firms to Manage your Strategy

Once you have decided on your strategic asset mix – how much in bonds and stocks, how much in your own country’s stock market and how much in foreign markets, its time to find the best people to manage each of these areas for you.

Selecting Managers

Questions to Identify a Good Investment Manager/Advisor

Each area of the market is specialized. And just like any profession – medical, legal, engineering etc. – there are specialists within the financial markets. Let’s think of medicine - is a really good brain surgeon going to be a really good heart surgeon? In the financial markets there are people who are good at managing bonds, domestic (your own home market) and foreign – and those who are good at managing stocks, domestic, and foreign. And within foreign markets there are a variety of regions and types of market specialists such as US or international (non-North American).

Managers execute their strategies through mutual funds, pooled funds, segregated securites and brokerage accounts.  Managers will have minimum investment sizes for each method they may use.

The people managing the strategy behind the mutual fund, pool or segregated account are the most important aspect to understand.  It's important to hire the best people in each area to execute each component of your strategy. I deliberately use the word "people" because people make the difference in everything in life - for better or worse. So when you are buying a mutual fund, what matters is the man or woman that is the portfolio manager and how long they have been managing the particular strategy with proven success. The person selling you the mutual fund has to be able to tell you all about the portfolio manager – not just give you the fund name and you buy based on brand. For investors going directly to portfolio managers to invest in a pool or individual stock/bond portfolio, please meet the portfolio manager/s and understand their experience with the strategy you are discussing.  If you are using a broker, understand on the team who makes the decisions.

The following linked document provides a few questions for you to use with a manager/advisor.   Ask these plus any additional questions you may believe are appropriate.

Questions for a Potential Advisor

Review of How to Access an Investment Manager

Let's step back for a moment and discuss a few ways that one can invest:

  1. You can invest in stocks and bonds yourself through a discount broker or a full service broker; or
  2. You can invest with portfolio managers (professional money managers) through a broker or directly through mutual funds, pooled funds or segregated (individual stock/bond) portfolios.

The size of your portfolio dictates which method you would use:

  • Mutual funds are typically for investors with $500 or more to invest
  • For pooled funds you typically need to have a net worth excluding your home of $1 million or more in Canada; earn $200,000 per year as an individual or $300,000 as a family; or be willing to invest $150,000 into the strategy
  • For segregated accounts there's no legal minimum however they are typically only available to investors with more than $1 million to invest (often much higher than this for some managers).

How to Short List Managers to Interview

There are hundreds to thousands of managers to invest in so how does one decide? The first step is to ignore marketing material. Remember that “numbers don't lie but liars can figure...”. Financial firms present their numbers differently from one another to demonstrate their best advantage. It's important to compare managers in a similar fashion. Apples to apples. Sounds easy enough however, it takes some effort to make this happen.

1. Any portfolio manager/strategy worth considering has a good performance track record over the past 7-10 years or longer. That means that they did well against the market index for their strategy and against their peers who manage the same strategy/asset class over the last 7-10 years or longer. There may be some exceptions. However, you need to sort out thousands of managers - thus performance is a starting place to sort out thousands of managers to a few that you will want to investigate further.

2. It's important that the portfolio manager has 10 years of experience or more managing the strategy you are considering.

3. It's not important that they are the best every year, as this would be impossible, but it is important that they are above average 2/3rds of the past 10 one year periods.

4. Therefore you would like to see the last 10 years of performance data on an annual (point 3) and annualized (point 1) basis - this means what they did each of every year over the past 10 years as well as what that means cumulatively in terms of return. AND you want to see this performance data against the universe of similar managers - their peers – as well as the benchmark – the market index.

Note:  Analyzing the performance numbers is 10% of your research/work.  Understanding the managers, who they are, what they do and how they do it is 90% of the research/work.  We'll discuss this later on.

The best way to ascertain the performance data is through a manager database system. Morningstar on the web provides a rating system for mutual funds and they also provide a system for pooled funds and segregated managers. They have different levels of access at different price points. Many of the discount brokers and full service brokers also provide mutual fund rankings and information as well. eVestment provides data for managers from Canada and all over the world.

For Canadians looking at mutual funds, Morningstar’s system is good. For family offices and wealthy Canadians I recommend either Morningstar or eVestment. If you have the financial resources and patience, often looking at more than one system can support or challenge ideas you may have.

One caveat to 10 years of history is that sometimes the data for this period is not available. Thus it is good to sort managers by 5, 7 and 10 years to get a sense of which firms are worth your consideration.

Within the information provided from these services you will find percentile or quartile rankings – how the manager has done against his/her peers as well as the appropriate market index. I like to see a manager be first quartile (top 25% of all managers in their asset class) over 7-10 years and above average (second quartile) or better over five years or less. A good Sharpe Ratio over a 5 year or longer time period is also nice to see (Sharpe Ratio is a measure of return per unit of risk as defined by volatility – the higher the Sharpe Ratio, the better the return per unit of risk). A good manager will not always be at the top of the charts. He/she will not always be first or second quartile in any single period (which is above average). However, they will be above average over a 5-10 year period.

For family offices and or investors with more than $5 million to invest, you may consider using Morningstar Direct or eVestment to run a variety of statistics on managers. Using eVestment as an example you can go into the Screen function and set a number of criteria for managers to meet. There is a wealth of information on each manager within these systems. Given that their cost is a serious expense and their capabilities are vast, if you are interested in these systems, I recommend you receive a tutorial from the companies directly and use both for a trail period.

Please note, there are times you meet a manager or hear about one and they are not in the system you use. In these cases, receive the performance data from the manager to compare against others you have identified.

The main point is that the first line of attack is to find managers with good performance and to make sure that the same portfolio manager is responsible for the historic performance. From there we want to make sure that we have the minimum amount of money required to invest in the managers we are considering – that we “meet their minimums”.

Researching your Short Listed Managers

  • Once you are convinced that a manager looks good from a performance perspective and you meet the minimum, the next step is to understand what they do and how they do it. When do they do really well? When does their strategy underperform? It's important to know this so that when they underperform, you understand what is happening and do not sell out of their strategy due to short term emotional frustration. I have included a PDF above with important questions to ask before you hire a manager. Discuss these questions with your broker selling you the manager or with the manager directly if you are going direct.
  • I recommend that you short list six managers for each area you are looking at as half of them will drop off following your questionnaire because they don’t meet your required answers. Then you will be left with three to consider for each asset class or mandate that you are looking for.
  • For the remaining three managers for each mandate/asset class, understand the fees you would be paying. If any one of three charge a fee significantly larger than the others, take them off the list.

Fees are important as the return you will receive is the return less the fee. A big word of caution, the investment industry is lousy at giving this information. So you have to be diligent in finding out ALL the fees you are paying – to everyone. You need to know custody fees, transaction fees, expenses, management fees and any commissions you will be paying. Are there any front end or back end loads? Ask whoever you are dealing with to write it all down for you – see it on paper. Ask if there is any aspect that is negotiable. If you are investing in mutual funds and paying altogether more than 1.5%, ask your advisor if he or she believes this is reasonable and why?

In the Blog you will find an section on Fees to help guide you in this process.

I have seen mutual fund portfolios where investors are being told they are paying 1% but when you add up all the associated fees, they are paying more than 3.5%. Completely unacceptable. Read the small print. Many believe that index funds or ETFs solve the problem of fees. However, in short, index funds and ETFs may have hidden risks and although they provide the market’s return, they do not manage market risk.  

  • Now that you have short listed the managers, which you believe you may like to work with, ask for three references – one that is like you, one that has been a client for a long time and one that has been a client for six months. Ask the references how they found the manager, how have they been serviced; what they believe the firm’s strengths are; and what they think the firm could improve on. See if the answers resonate with you and if they are consistent between references.
  • If you are working with an advisor/broker for mutual funds, ask him/her how much money they have collectively with all of their clients in each fund; what they like about the professional/s managing the strategy; how they know the professional will stay managing the strategy; how will they know when the professional leaves; will they tell you; and how does the broker/advisor get paid from this fund and how much is it?

IT IS ALL ABOUT THE PEOPLE. Remember that when you are buying a mutual fund or investing with a professional money manager directly, you are not buying their brand name, you are hiring the professionals behind the name to manage a mandate/asset class for you that they have demonstrated success with over a business cycle (7-10 years). You are hiring the PEOPLE.

When you are investing with a manager, do so with the expectation that you are planning to stay with that manager for 10 years or longer. You have to stay with a manager through a business cycle, at minimum, to make good returns.

When Do You Sell A Manager?

Most investors decide to leave a mutual fund or portfolio manager after they have had poor performance for a year or so. This is a classic mistake. Investors will buy a manager based on good historic performance and sell them on short term recent underperformance. Thus most investors buy high and sell low. Please never buy or sell a manager solely on performance.

As mentioned above the key factor in hiring a manager/mutual fund is the PEOPLE. So the key factor in terminating a manager/mutual fund will also be due to something impacting the key person or people at the firm.

If the key portfolio manager resigns or retires, that is a simple sign that the manager needs to be reviewed. In 90% of the cases, this will lead to the termination of the manager as the key success factor is no longer at the firm. The 10% exceptions are where the firm does have a good succession plan that has been in the works for several years (i.e. they didn’t dream it up last night in preparation for your meeting). The professional taking over the strategy has been integral to the strategy for five years or more and be experienced. Experienced is a subjective word. For me, it means the person taking over has demonstrated for 10 years or more successful portfolio management. You need to see this demonstrated – not just in words. If you believe the succession plan is reasonable, you can wait and see how the new portfolio manager does.

Another obvious sign is the sale of the manager to another firm. In that case you have to find out what is going to happen to your manager and the implications for the key people at the firm.

Often the signs are less obvious. It may be a small thing that is a symptom of a larger issue at the firm. It is hard to describe these issues. However, what I would say is that if anything happens that doesn’t sit right with you, investigate it further – see if the situation leads to more information. If it leads to something that will negatively impact the key people at the firm, time to go.

Sometimes the key people can remain the same and the ownership remains the same but the key people have decided to change what they do for investors. Either they change their strategy or add many new products. As hard as it may seem to be, time to go.

When you decide to leave a mutual fund/manager, the portfolio will not change significantly over the next three months – thus this is how much time you have to find a new manager to replace the existing manager you are terminating. Take your time to find a good replacement. And remember, when you hire or terminate a manager, you may be wrong sometimes. That is okay as long as you are disciplined in your approach and are right more often than you are wrong. Learn from every decision you make and please, never make an emotional decisions based on how you “feel”.

How Many Managers/Mutual Funds Are Appropriate In A Strategy?

One man or woman cannot cover all asset classes or regions of the world. The world will offer opportunities to you over your life as an investor. Thus, the number of managers/mutual funds in a strategy depends on what your strategy is and the range of opportunities you are looking at including.

Generally you would want:

• A domestic bond manager (i.e. in Canada, a manager managing Canadian bonds)
• A domestic equity manager (i.e. in Canada a manager managing Canadian equity)
• One to four foreign equity managers (i.e. Global equity, US equity, European equity, Asian equity; international equity and/or emerging markets)

I have not included hedge funds here. I will address hedge funds separately below.

Again, it depends on the size of your portfolio as to how many specialists you will use. When you are starting out, you may have one balanced mutual fund dealing with all asset classes and then move to a bond manager, a domestic equity manager and a global equity manager through mutual funds. As your portfolio grows, you may move to pools or segregated management and add a few more specialists. I would rather see a portfolio with fewer high quality managers than many managers. However, it is always a personal decision.

Hedge Funds

The origin of hedge funds was in the 1960’s when the idea arose of trying to mitigate negative stock markets. Over time this concept remained while many new “hedge fund” strategies emerged. Today there are about 100 classifications of hedge funds. They all have different approaches to the market and different reasons why they would add value to a portfolio strategy.

One thing they have in common are typically large fees in the order of 2% management fee plus 20% of positive returns. There are also many variations on this fee structure.

After looking at hedge funds for over a decade for clients I have come to the conclusion that the only reason ever to consider using a hedge fund, is if you want to invest with the specific manager/person and they only offer their management in a hedge fund structure – and they have demonstrated that they pay for themselves.

If you would like to invest in a hedge fund:
• ask the manager for their AIMA questionnaire.  This document should explain the fund in detail.  Also ask to see the Offering Memorandum or Prospectus;
• look at the portfolio holdings with the manager – if he or she is not willing to let you see the portfolio, then I recommend you not invest;
• understand the liquidity of the fund (typically 1-12 months to receive your funds when you would like to redeem) and make sure you are comfortable with it.  These details should be outlined in the AIMA document and the Offering Memorandum/Prospectus;
• ask for three client references; and
• think about how the strategy will fit into your overall strategy.  Does it makes sense and complement your other managers?  Or are you just doing it for fun?

I would also recommend that in general, you not have more than 10-20% of your portfolio invested in hedge funds.

In the Blog there will be sections on hedge funds over time.