You should look for five things when choosing a fund manager to manage your investments, and past performance is probably the least important (see “Past returns are of less importance”, below). This is according to David O’Leary, head of fund research in South Africa at Morningstar, which rates domestic and global funds.
O’Leary says that, although good performance is a key consideration, it is often not very fruitful, and you should look for at least four other characteristics in an asset management business: talented people, a consistent investment process, an ethical parent company and a good price for service.
1. The right people
O’Leary says that when he assesses how talented the people who manage funds at an asset manager are, he checks not only whether the company has employed good-quality people with the right experience, but also if they are the right fit for the asset manager.
He also asks how they are incentivised and whether they, personally, invest in the funds they manage.
Typically, a fund manager earns a salary and a bonus, and, ideally, the bonus is aligned with the long-term performance of the investments, O’Leary says.
Incentives are misaligned when the bonuses of investment professionals are tied to the size of new investments in the fund (sales) or to the profitability of the asset manager, O’Leary says.
Companies that align bonuses to sales typically argue that sales rise when performance is good, he says.
However, the best way to incentivise fund managers to produce good performance is for them to have a meaningful amount of their own money invested in the funds for which they are responsible.
Unfortunately, the United States is the only country in which asset managers are required to disclose if their investment professionals are invested in the funds they manage.
Fund managers often say, when they select shares for their funds, that they look for companies where the management has invested in its own shares – known as having “skin in the game”, O’Leary says.
Investors should ask fund managers how much skin they have in the game, he says. If investors and financial advisers always ask for this information, disclosing their own investments in the fund will become a cost of being in the position of an investment professional.
Morningstar has found that there is a direct correlation between how much money a fund manager has invested in the fund that he or she manages, how well a fund performs and how long a fund manager stays with an asset manager, he says.
The higher the amount invested, the better the performance and the longer the manager stays with the company, O’Leary says.
According to research done in 2010, out of all the domestic equity funds in the US, where managers had at least US$1 million of their own money invested in a fund, the average fund had a five-year return that ranked better than 61 percent of its peers, O’Leary says.
2. Consistent investment process
There is not one right way for a fund manager to earn returns for you, O’Leary says, but managers that provide good returns have an investment process that they can define, and they stick to it.
A fund manager should be able to explain his or her investment process to you in a way that you can understand, and you should see evidence of that process in the fund’s holdings, he says.
If you don’t understand the manager’s investment process, don’t just take a leap of faith and hope that the manager knows what he or she is doing, O’Leary says.
The fund manager should also be able to tell you the market conditions under which the fund will perform well and badly. If the fund’s performance is inconsistent with this expectation, the manager is not sticking to his or her process consistently, and this kind of behaviour is likely to result in the fund losing value, O’Leary says.
3. Ethical parent company
You need to assess the character of the company that provides the fund in which you want to invest, to find out whether it will put you, the investor, first, O’Leary says.
It is unrealistic to expect a company not to want to make a profit, but it is important to establish where you, the investor, feature on the spectrum between salesmanship and stewardship.
A company involved in salesmanship is interested only in selling everything and anything to anyone who will buy it, but a good steward will offer worthwhile investments in which it has a competitive advantage, O’Leary says.
Companies concerned only with sales have a habit of closing funds when markets are performing badly, and launching gimmicky funds in a market that is doing well, he says.
To determine if your fund manager’s parent company is a good one, consider these four things:
* The corporate culture. You need to get to the DNA of the firm, read its financial statements to understand its culture and what makes it different, he says.
O’Leary says that he listens in on asset managers’ discussions with analysts to find out how they explain their business to shareholders, as well as their attitude towards investors.
Another factor O’Leary considers is the turnover of staff at an asset manager. If it has a low turnover, you know that things are healthy beneath the surface.
Read a company’s communications, its website and its fund fact sheets. If you don’t know much about the company after reading these, it tells you something about the company’s attitude to investors and advisers, or it may be because the company is disorganised, O’Leary says. Either way, you may not want to invest with it, he says.
* Whether the company is in the news a lot because it contravenes regulations or is being sued.
* The incentives offered to its investment professionals.
* The fees the manager charges. The lower the better, but they may not all be the lowest, O’Leary says. What you should determine is whether the company charges the highest fees on all of its funds in their respective sub-categories and whether the company’s total expense ratio shows that, over time, it passes on to investors the economies of scale it achieves as its funds grow in size.
O’Leary says that, in the US and Canada, Morningstar gives funds a stewardship grade based on its view of the funds’ parent companies.
Research by Cornell and Binghamton universities has found that funds that receive good stewardship grades (A or B) deliver performance that is, on average, 1.6 percentage points higher than funds that are on the two lowest grades (E or F).
4. Fair price
The fees charged by a fund are often the best predictor of their future performance, because the bigger the fee, the greater the hurdle to performance after fees, O’Leary says.
Many South African unit trust funds charge complicated performance fees, he says. Depending on how the performance fee is structured, the fund may not, as is commonly expected, pay well for good performance and pay nothing for bad performance. Often, a fund has base fees that ensure the manager is paid despite poor performance, O’Leary says.
Performance fee structures may have unintended consequences, and you, as an investor, may not know the type of behaviour a fee is eliciting. For example, he says, to earn a high fee, a manager may invest more conservatively than it normally would in order to preserve a good performance track record.
With a few exceptions, there is no need for performance fees if the fund manager is invested heavily in his or her fund, O’Leary says.
PAST RETURNS ARE OF LESS IMPORTANCE
Analysing past performance to determine which fund manager you should use is useful only if you can distinguish between performance that was the result of an investment team’s skill and that which resulted from luck, David O’Leary, head of fund research in South Africa at Morningstar, says.
It is difficult to call asset managers that have been performing well for 20 or 30 years “lucky”, O’Leary says.
But most managers have not had the same investment professionals for 20 or 30 years, and typically the individual who manages a fund has changed in the past three or four years, he says. The time it will take to do research into past performance may make the exercise less worth your while than looking for the other characteristics that are the hallmarks of a good fund manager.
O’Leary says that good performance does not always create good experiences for investors. You should not underestimate how volatility can elicit the wrong behaviour from investors, he says.
It is human nature to respond with good feelings to a fund that is performing well and to sell one that is doing badly, but the investment processes and market cycles of most funds take them through up and down cycles.
When investors disinvest during a fund’s down cycles and reinvest when the fund is again producing good returns, they ruin their chances of earning the returns the fund manager achieves for the fund. The investors’ returns will be different to the time-weighted returns measured for the fund over a particular period.
O’Leary says it is not inconceivable for a hypothetical fund in the United States to have returned 15.05 percent a year between 1997 and 2006, whereas the investors in the fund received an average negative return of –1.46 percent. This is because investors typically invested when the market peaked in 1999 and disinvested throughout the subsequent market fall and the market recovery from 2003.