Managing the managers: Look beyond the numbers

With thousands of investment options from which
to choose, selecting top-
performing funds can be a complex and time-consuming task.
An equally challenging job is determining whether to replace an underperforming manager.
In making this difficult decision, advisers often rely on broad-based performance screens — for example, firing managers whose performance has slipped below the top quartile of a peer group over a three- or five-year period.
Given that study after study has proven that past performance is a poor predictor of future results, this is an ineffective strategy.
Instead, advisers should consider the following guidelines when deciding whether to replace an underperforming manager.
Revisit the hiring decision. It is impractical to evaluate an underperforming manager without first revisiting the rationale for hiring that manager.
In fact, a robust selection process — including both quantitative and qualitative analysis — is the foundation for an effective replacement philosophy.
Although most advisers would agree that a successful selection process includes in-depth quantitative analysis, many fail to include the most critical element: qualitative analysis.
In this stage, the manager should be asked, face to face if possible, to pinpoint what has made the fund successful and to articulate why its investment performance is repeatable.
These elements of success can be termed the manager’s value proposition. Examples include:
• A disciplined investment process that leads to style con-
sistency, regardless of market
environment.
• A global research platform that consistently leads to positive stock selection across a wide range of
sectors.
• Extensive use of proprietary risk models, leading to minimal downside results.
Defining and testing the value proposition helps the adviser make an important judgment: Has the manager’s excess performance over time been the result of luck or is it the product of a consistently applied investment process and philosophy?
The manager should be asked to demonstrate how specific holdings, over various time frames, are related to a unique investment strategy.
This can help the adviser determine if the composition of the portfolio actually embodies the manager’s stated skills.
Most great managers are able to clearly articulate — and illustrate — how they have made money over time.
Avoid making a snap judgment. Because investment styles naturally fall in and out of favor, even great managers can be expected to underperform at some point.
The key is to recognize that poor performance over short-term and even intermediate-term time frames is simply an outcome and may not have any predictive power as it relates to future performance.
There are several potential scenarios where a good manager might encounter performance issues that aren’t the result of a real underlying problem, such as:
An out-of-favor style. Consider a large-cap-value portfolio whose highly defensive approach focuses on identifying former blue-chip companies that currently are cheap.
This “deep value” strategy means that when growth investing is in favor, the fund likely will underperform its peers — specifically those that take a more relative value approach.
Although they should remain patient, some advisers may replace the fund at times when growth significantly outpaces value, such as in the late 1990s.
Improper classification. Although the style boxes produced by fund trackers such as Lipper Inc. of New York or Morningstar Inc. of Chicago can be helpful, they sometimes
fail to reflect the true nature of a portfolio.
This often is the case with “go anywhere” funds, whose managers look for the best investments regardless of market capitalization or asset class.
These funds tend to land in a variety of style boxes and often are judged against peer groups of dissimilar funds.
Because of these potential issues, advisers should fully examine a fund’s investment approach compared with its classification before writing it off for poor performance — or buying it for great performance.
A bad apple. A good manager might underperform if one or two holdings are temporarily dragging down performance.
This issue is magnified for managers with relatively few holdings.
Often, more concentrated managers are comfortable holding on to high-conviction names for long periods of time — often years — as they wait for the position to work out.
If this is what the manager was hired to do, advisers also should be patient.
Manager turnover. Long-tenured managers have honed their processes in a variety of markets and may have an advantage over less experienced managers. In fact, some studies have shown that manager tenure is a good — though certainly not perfect — predictor of future results.
However, while experience is undoubtedly an important consideration, manager turnover isn’t always a negative event.
Instead of making an automatic replacement, the adviser should evaluate the new manager to determine whether it will be able to effectively execute the original strategy.
Repeat the original analysis. The above examples illustrate that while a short-term issue should raise a red flag, it shouldn’t, on its own, constitute sufficient grounds for replacement.
Instead, poor performance should trigger a repeat of the extensive quantitative analysis conducted when the manager initially was selected.
This review may help the adviser pinpoint the specific factors that have contributed to the performance problem.
For example, analysis may uncover that a manager who was expected to have a persistent style bias actually is moving around
to capitalize on opportunities throughout the market — or a manager who was expected to outperform when value is in favor is struggling in a value-driven market.
Consider the value proposition. In addition to reviewing the quantitative analysis that originally was conducted, the adviser should revisit the value propositions established when the manager was selected.
If a value proposition has been violated, the manager essentially no longer is delivering on the promise to the adviser.
Take, for example, a manager who states that his team will “leverage the firm’s state-of-the-art global-research efforts to deliver excellent stock-picking gains and will not need to make country or sector bets.”
Analysis shows that the stock-picking numbers are negative over several quarters and that the manager has made most of his gains in rotating among countries.
Value proposition violations shouldn’t, however, result in immediate replacement, as they are rarely black and white, and each situation is different.
If the adviser has spent a significant amount of time conducting a thorough selection process, it is reasonable to assume that he should have long-term confidence in the managers chosen.
Unfortunately, a full review may uncover some factors that have caused this level of conviction to change.
If, after the review, the adviser thinks that the manager won’t perform in the future and that a viable alternative exists (the latter is an especially challenging issue in capacity-constrained asset classes such as small-caps, where there are few high-quality alternatives that remain open to new investment), the manager probably should be replaced.
Steve Medina is senior vice president of investment management services at John Hancock Financial Services Inc. of Boston.

Related Topics: Investment Strategies