Focusing on historical performance is the classic error in choosing a money
manager. Several studies have shown that the top performing manager in one
period typically underperforms in the next period. That is why it is important
to choose a manager that has good and consistent performance over longer time
periods.
The rule of thumb in the industry use to be moving four year returns (the
return over the past four years) in different periods. This permitted the client
to assess the manager over a complete market cycle. With the market and economic
cycles lengthening over the past two cycles, an even longer period might be
appropriate.
Historical performance is only a sound predictor if the investment
philosophy, process and personnel of a firm are the same as over the period the
track record was established. Money managers are highly paid, sometimes with
egos to match. This leads to fairly high turnover in the industry, and
prospective clients should identify that the key personnel are still in place.
Often when a firm underperforms, it comes under strong pressures from
clients and consultants to improve this "underperformance". Since the
underperformance could very well result from the manager's style or security
selections being out of favour, a change could come at exactly the wrong moment,
when the style and securities are coming back into favour and will outperform. A
good investment counselling firm is convinced of its style and will not stray
for the wrong reasons. A value firm probably won't be doing well in a highly
speculative market where growth and "momentum" investors are bidding
up stocks to very high prices. The pressure to change, however, is likely to
come at the high point for this type of stock and a change out of "dog"
and laggard value stocks into these stocks would be disastrous!
The key thing to look for in an investment manager is a sound and
disciplined investment philosophy. The next thing is to review the
investment process, particularly security selection. Things should be
understandable and reasonably simple. If you can't understand it, the manager
probably doesn't.
A historical track record is only evidence of skill. A proper investment
manager search will establish whether the historical performance is skill or
luck. If a successful portfolio manager has left his or her previous firm and
strikes you as a sound and capable investor, that's probably more suitable
evidence than relying on the historical track record of a larger established
firm who has lost most of its key investment personnel in the past few years.
Article by John Carswell, Canso Investment Counsel Ltd. |