Portfolio Advisors
Portfolio Advisors
Broadly speaking, the fund's investment portfolio can be managed in one of two ways. It can be administered internally, by staff who are an integral unit of the fund's management. Fund groups such as Trimark or Templeton use this "in-house" approach. Alternatively, the portfolio may be administered externally, by advisors who contract their services to the fund. Fund groups such as CI, 20/20 Financial [now merged with AGF] and Spectrum United have adopted this "hired gun" arrangement.
The chief rationale for the use of external advisors is that it provides fund investors with access to the best available talent. 20/20 Financial, for example, explained its use of contract advisors as follows: We don't believe in having salaried managers on staff. In one, or two locations, sharing a common corporate culture and reporting to management committees, is the most effective way for us to run an investment fund. Major pension funds and wealthy individuals seek out and hire the world's best managers, the same way sports teams become winners by handpicking the top free agents.
To determine whether this rationale is justified, we compared the performance of funds using external portfolio advisors to that of funds with in-house advisors, using data available on Bellcharts. Of the 64 Canadian equity funds with a ten-year track record as of December 31, 1995, 46 were advised in-house, and 14 contracted externally for advice. Four funds offered by Manulife Financial were excluded because they are advised by Altamira, which is partly owned by Manulife. While these funds technically rely on external advisors, they more closely resemble fund with in-house advisors because of the relationship between Manulife and Altamira.
The average ten-year compound return of the 14 externally advised funds was 7.6%, while the average ten-year compound return of the 46 funds advised in-house was 7.9%. Interestingly, the inclusion of the Manulife funds in the in-house group did not affect the results.
The chief limitation with this analysis is that there are some cases in which funds have used both in-house and external advisors during the ten-year period under review. The Spectrum United Canadian Equity Fund, for example, was advised in-house by Jerry Coleman and Gerry Javasky until 1992, when responsibility for portfolio advice was contracted to Kiki Delaney. That caveat aside, it seems reasonably clear that the difference in performance between the in-house funds and the contract funds is insignificant, and that contracting portfolio advice to outside advisors does not improve performance.
Relative performance is not however the only consideration in evaluating
a fund's management. One of the most important characteristics of good
management is its stability. If a fund's portfolio advisors are constantly
changing, its past performance is unreliable as a guide to future
performance.
In our view, there is a much smaller likelihood that there will be dramatic or abrupt changes in the responsible personnel when the portfolio is advised internally. In many cases, those responsible for portfolio investment were founders of the fund or fund group. Bob Krembil at Trimark, Peter Cundill at the Cundill group, Robert Farquarhson at AGF, Alex Christ at Mackenzie Financial and Ned Goodman at Dynamic are all examples of portfolio managers who created their own funds. Even if the short-term performance of their funds lag, it is unlikely that there will be wholesale changes in the investment group.
The same cannot be said of funds which employ external portfolio advisors. It is, quite simply, easier to sever a merely contractual relationship than it is to remove personnel who are an integral part of the fund's organization. As a result, it is far more likely that relatively short-term underperformance will precipitate a change in advisors. The philosophy of 20/20 Financial, for example, was to "attract top performers and keep them only so long as they deliver results" [emphasis added].
The difficulty with this attitude is that it fails to allow for the inherently cyclical character of portfolio management. Every portfolio manager has periods of both weakness and strength, but it is frequently possible to distinguish between cyclical variations and a more substantial deterioration in performance only by taking a long-term perspective. The relative ease with which an external advisor can be replaced does not, however, encourage such a long-term outlook, and may result in the removal of the portfolio advisor from the fund just as its performance is about to improve. Even more damaging is the fact that the portfolio advisor assuming responsibility is often chosen because of its recent strong performance at some other fund. Almost inevitably, this superior performance fades. The consequence is that the fund's lagging performance is prolonged rather than shortened.
Marketing considerations contribute to this instability. In an effort to capitalize on the enormous interest in mutual funds, many fund groups have greatly increased the number of funds they offer over the past few years. The result has been intense competition for investor dollars, and in the quest for ways to differentiate funds, the use of external advisors has been exploited to enhance a fund's cachet. Funds invariably describe the reputation of their external portfolio advisors as 'exceptional', and the relationship between the fund and the advisor as 'special'. In fact, only a very few advisors are truly superior, and the reality is that the 'special' relationship lasts only so long as the advisor's performance is robust. In September, 1993, for example, Global Strategy described AsiaInvest, one of the advisors for the "multi-manager" Asia Fund, as follows: a young, performance-driven boutique set up and run by locals in Hong Kong. Walter Wu, who is the key investment guy...was named top fund manager of the year last year [1992] both by the consultants Micropal, and the influential Asian daily, the South China Morning Post....[They] are among the best managers in the world. [emphasis added].
Yet despite this glowing description, Global Strategy unceremoniously dumped AsiaInvest only 18 months later, in March 1995, citing mediocre performance and replacing them with Schroder Capital Management Ltd., which it described as "one of the strongest investment managers in the world."
A fund's comparatively low level of commitment to external advisors is often matched by the attitude of the external advisors. Some general studies of management behavior suggest that external management is less committed to the long-term success of an organization than internal managers. There is evidence that managers who do not have a stake in the organization are more likely to pursue strategies which put their own interests ahead of the organization's interests. In the context of mutual funds, this may mean that external portfolio managers, who are more susceptible to abrupt removal, are more likely to pursue strategies emphasizing short-term performance in an effort to bolster their own positions and reputations. Internal portfolio advisors, with a vested interest in the viability of the fund, are more likely to pursue approaches which maximize long-term performance.
The consequences of the 'star manager' phenomenon reflect both this concern and the preoccupation with marketing considerations. In characterizing its portfolio advisor as a 'star', a fund enables often unsophisticated investors to put a name and face to portfolio decisions, and differentiates itself from the competition. The difficulty is that external portfolio advisors, like free agents in professional sport, often have little loyalty to the funds they advise. In a little more than two years, for example, Jonathan Baird has shifted his allegiance not once but twice. In September, 1995, he moved from the Dynamic group to the University Avenue group. Only one year later, he announced plans to assume management of a new fund to be offered by the CI group, and to devote himself exclusively to CI once his contract with the University Avenue group expired. Similarly, Veronika Hirsch moved with great fanfare from the Prudential group to the AGF group in September, 1995, only to accept an offer from Fidelity in July, 1996.
External advisors also have to contend with potential conflicts of interest. An external advisor typically has several funds as 'clients' and the same investment choices will often be suitable for more than one client. There will inevitably be conflicts about the allocation of such investments when they are available in only very limited quantities. The prospectus of funds employing external advisors often devotes considerable attention to explaining the way in which potential conflicts will be resolved, but the external advisor is frequently requried to strike a compromise which is less than ideal.
Recently, a number of funds have developed a hybrid relationship, of sorts, between internal and external portfolio advisors, in which the fund's manager holds an equity position in the firm from which it contracts for portfolio advice. Trimark, for example, has recently taken an equity position in Lloyd George Management, which provides portfolio advice to the Trimark Indo-Pacific Fund.
By using external portfolio advisors, the fund acquires immediate access to expertise on distant regions which it would be slow and difficult to develop internally. However, by creating institutional rather than merely contractual links between the advisor and the fund manager, the lines of communication with the internal advisors of other funds in the group are strengthened and deepened. While it will unquestionably be more difficult to terminate such an advisor if the relationships does not work, the equity interest signifies that a long-term relationship is anticipated.
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