The investment manager selection process is a lot tougher than you might think. It requires time and patience and knowing not to rely too much on her historical performance.
Choosing an Investment Manager
The investment manager selection process is much like choosing a stock. It sounds easy up front, but assembling the required information and finding the time and abilities required is a daunting task for those who aren’t professional investment analysts. Choosing a money manager is like choosing a spouse. It is better to choose wisely up front than to try to sort things out along the way when things get tough.
Investment Manager Selection Considerations
How the Professionals Select Managers
Screening by historical record and investment style, the prospective client develops a “long list” of potentially suitable investment counseling firms. The prospective client asks the investment counseling firms on this “long list” to answer a questionnaire which asks detailed questions about the firm’s organization, capabilities, investment philosophy and process.
Culling down the “long list” to four to six potentially suitable firms, the prospective client arranges a “short list” presentation where she interviews the management and key personnel of the investment counseling firms. The prospective client then chooses a manager from the short list candidates.
At this point, it is obvious that choosing an investment manager is a very time consuming process requiring quite a bit of expertise and knowledge. This is why most large clients hire an investment consultant to help them select and review their managers. Very large and sophisticated corporate funds usually hire an investment consulting and performance measurement. Large actuarial consulting firms have “asset management” teams that perform the same function. These firms maintain databases of investment counseling firms’ performance and maintain up-to-date files on the characteristics of each firm. These firms bill their consulting services on a fee basis or act on retainer for their clients.
Where to Find the Relevant Information
To aid the investment manager selection process, prospective clients can obtain the names and addresses of investment counseling firms from industry directories, such as Benefits Canada. Some actuarial firms have pooled fund performance surveys that cover most of the larger managers’ pooled funds in Canada.
Smaller clients and individuals also have access to financial planners who keep tabs on managers who specialize in smaller and private accounts. Accountants and estate lawyers have contacts with money managers, as many of their clients use the services of discretionary investment managers.
At lower levels of assets (below $500,000 in a total portfolio) the prospective client should really use mutual funds, as these are much more efficient when transactions and custodial costs are taken into account. Investment dealers offer “wrap accounts” which either use pooled funds or invest client monies in a “model portfolio” approach for a single asset based fee. These are comparable to mutual funds and can be tailored more for specific client groups.
Most investment dealers and mutual fund brokerages are familiar with the investment managers of the various mutual funds available. Some firms have investment analysts dedicated to following the mutual fund industry and are very familiar with both the firms and particular fund managers. The financial press publishes mutual fund performance on a monthly basis and provides quarterly analyses of fund holdings. They also have reporters who follow mutual funds and do special reports on investment counseling firms.
What Account Sizes are Necessary?
Most large investment managers have high minimums for client accounts.
A cut-off point of five to ten million dollars is not unusual for institutional money managers. Fortunately, many of these managers have private client divisions with lower minimums, usually ranging from $500,000 to $1,000,000. Below this level, they use “pooled funds” which are unit trusts, like mutual funds, but are only available to clients with a minimum of $150,000 in each pooled fund. There are many smaller investment counseling firms with lower minimums for segregated funds. Banks, trust companies and investment dealers also have investment management divisions which manage money for their firms’ clients.
Investment Manager Selection Issues to Consider
When choosing a manager, focusing on historical performance is the classic error. 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 used 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 favor, a change could come at exactly the wrong moment, when the style and securities are coming back into favor and will outperform. A good investment counseling 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.
Key to Choosing an Investment Manager
The key thing to look for in the investment manager selection process is a sound and disciplined investment philosophy. The next thing to review is 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 manager search will establish whether the historical performance is skill or luck.