As South African professional golfer Gary Player was famed for saying, “the harder I practice, the luckier I get”. This fine line between the nurturing of skill and the randomness of luck has great importance in the investment management industry, especially when assessing fund managers.
There are questions at the current juncture that insinuates active management could be a dying breed. With asset managers such as Blackrock ‘restructuring’ their active offerings and passive investment continuing to attract inflows, it raises many questions about the relationship between luck and skill. If skill is deemed to be irrelevant in today’s world – akin to efficient market theory – then the lowest fee offerings will continue to win. Yet, while we continue to acknowledge the importance of keeping fees low, we do believe there is sufficient evidence to suggest that skill does matter.
How Can We Find Skill?
The question is often raised about how we deal with this balance between skill, luck and cost. The obvious first step is to have a preference for low-cost investing. These investors have a lower hurdle rate and therefore require less skill to win. It is akin to handicapping in golf. Yet unlike golf, the highest skilled investors can also have the lowest cost and vice versa. Therefore, we ideally want to find highly skilled investors at low cost and avoid the lowly skilled investors with high costs.
This is the primary role of the manager selection process. We want to remove luck from the equation and focus intently on the relationship between skill and cost.
We would argue that identifying fund managers who consistently deliver alpha over time is indeed possible but that it requires a qualitative investment research approach; one which is in depth and forward looking. This is time consuming, continuous, and requires high levels of expertise.
How Do We Assess Fund Managers?
Our methodology and approach is well documented and articulated as the “5 P” framework under which we consider all funds.
People – The overall quality of a fund’s investment team is a significant key to a fund’s ability to deliver superior performance relative to its benchmark and/or peers. It’s extremely important to establish which individuals make the key decisions on the fund; if there is more than one person in charge, how conflicts are resolved; which resources directly support their work on the strategy; and which resources they access that are not part of the team
Process – We look for funds with a performance objective and investment process that is sensible, clearly defined, and repeatable. It must also be implemented effectively. In addition, the portfolio should be constructed in a manner that is consistent with the investment process and performance objective. We seek to understand the context in which managers define and manage risk as well as how this is expressed when constructing the portfolio. We look for funds with a process distinctive enough to generate standout results in the future.
Parent – We believe the parent organisation is of utmost importance in evaluating funds. Although other factors may have more immediate impact, they would not be sustainable without backing from the fund firm. Further, the fund firm and its management set the tone for key elements of our evaluation, including capacity management, risk management, recruitment, retention of talent and incentive pay. Beyond these areas, we prefer firms that have a culture of stewardship and put investors first to those that are too heavily weighted to marketing and sales results.
Performance - We do not believe past performance is necessarily predictive of future results and this factor accordingly receives a relatively small weighting in our evaluation process. In particular, we strive not to anchor on short-term performance. However, we do believe that the evaluation of long-term returns and risk patterns are vital to determining if a fund is able to perform to our expectations.
Price – Morningstar and independent academic research has shown that fund expenses are one of the better predictors of future outperformance even when evaluating net-of-fee returns. Given this, costs cannot be ignored.
Knowing What to Look For
Once we have established exactly what it is that a manager is trying to achieve and how he sets about doing this, we are able to assess and monitor their ability to do this on a consistent basis and to ascertain to what extent their success represents skill or can merely be attributed to luck.
This acknowledges that a bit of luck often goes a long way too and there are countless examples of instances where managers were also able to benefit from a decent measure of luck too. Ultimately though, the management of funds that can deliver strong outperformance for their investors after fees require a significant amount of skill, and above all, requires fund managers to adopt a long-term approach, to invest with a clear investment philosophy and process, to invest with conviction and to have the courage to remain the course and be willing to go against the crowd from time to time.