By David Crosoer and Prieur du Plessis
WE REPLACE unit trust managers when we no longer think they are better than average. In our view, above-average specialist managers outperform their market benchmarks, while above-average multi-asset managers need to outperform their peers.
Managers may become mediocre for various reasons, and our investment process focuses on the internal rating of three qualitative pillars rather than short-term (under)performance.
These pillars qualitatively assess whether managers are above average in terms of their organisational structure and stability; people and support; and their investment approach.
In the organisational structure and stability pillar, for example, some of the areas we focus on are misaligned incentives, lack of majority control, and inability to reach critical scale.
This pillar also looks at whether the firm is managing its own evolution appropriately, or is ill-placed to succeed. Material issues that could also concern us include key client concentration, lack of focus, and product proliferation.
The people and support team pillar includes assessing the implications of staff turnover, and key-person dependency, but also diversity and inclusion and the extent to which the investment team culture can continue to generate new ideas.
A useful framing for this pillar (to assess whether it remains above average) is to ask how easy it would it be for a competitor to replicate the team, and in what way the people and support pillar remains more than the sum of its parts.
Finally, investment approach is focused on our confidence that we have identified a manager’s enduring edge that has been applied consistently.
Managers that don’t do what we expect of them, or arbitrarily change their approach, would get penalised in this regard. We’d also be sceptical of approaches that are easy to replicate or don’t appear to have significant barriers to entry.
We maintain a four-point rating scale for each of these pillars. Managers that score a 1 or 2 on any of these three pillars can no longer be included in our portfolios.
What reasons would we have to mark down a manager that we previously rated above average?
First, our process deliberately tries to protect us from downrating a manager simply because it is performing poorly, but rather draws our attention to whether we think the manager remains best in class.
This is because in responding to short-term underperformance, many of us terminate a manager at precisely the wrong time, to the detriment of future portfolio returns.
Second, we maintain a record of all our previous rating downgrades, which we can refer to, in framing how to approach our current decision.
While it is important to view each case on its own merits and not default to uniformity simply for the sake of it, it is also important to have some consistency in how we rate managers. At the very least, we should know why we are making an exception with a particular decision.
For example, a surprising launch of a new strategy from a manager could lead to a ratings downgrade if we felt it would distract the investment team.
However, this would not automatically result in a rating downgrade, and the materiality would be thoroughly discussed before reaching a decision.
Regardless of the decision, careful documentation helps our process evolve over time and ensure the next decision would be framed even more comprehensively.
While the decision to replace a manager is often because the manager’s process has degraded, rather than the manager has been left behind by its peers, it is also important to assess whether the manager has not moved with the times.
Again, there is a tension to the manager sticking to its investment process, and being agile to adapt to a changing environment, where necessary.
Examples here include how the manager thinks about ESG or the return to the office in a post-Covid world. In both cases we would expect the manager to have thought deeply about these issues if it is to remain best in class.
In short, replacing a manager is seldom straightforward, and may be done at the wrong time.
Remain open to learning from previous termination decisions that may have been wrong, as well as the material red flags that were ignored. Carefully documented learnings and institutional memory can help to inform future decisions.
Focusing on forward-looking risks and opportunities rather than backward-looking performance, and challenging the thinking that the manager is truly exceptional, is a helpful starting point in framing the decision.
David Crosoer and Professor Prieur du Plessis are chief investment officers of PPS Investments and chairperson of PPS Multi-Managers respectively; email: [email protected].
*The views expressed here are not necessarily those of IOL or of title sites.
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