Money Matters

How to Choose an Investment Manager

Some people like to choose their own shares and construct their own portfolios. And many do very well, though by no means all. Running your own portfolio takes time and you may have to deal with issues like Capital Gains Tax. As we have already seen the stock market goes up more than it goes down and if you simply invest in a fund that buys all the stocks in the stock market in proportion to their size, called a tracker or an index fund because it tracks an index like the FTSE 100, you will receive an average return, before fees, of about 6.7%. So that is the minimum an investor should receive, on average. The advantage of this type of fund is that it is also low risk. Because it invests in all the stocks it captures all the returns and avoids the danger of not holding a company that suddenly does very well. Equally, it will hold stocks that don’t do very well. As a result it can never outperform and for that reason it cannot add any value. In technical language that it means it will always have a low alpha ratio and its beta ratio will be less than one.

Any fund that is actively managed, by a fund manager, should deliver a bit more than that. He, or she, does this by avoiding shares he thinks expensive and buying more of the ones he thinks are cheap. His, or her, basis for selecting shares comes from research and perhaps from meeting the company and hearing first hand what it is doing and what its prospects are. However, this is time consuming and is not always that productive in a world where inside information is illegal.

Tracking the performance of active fund managers is a full time job and Bestinvest and Citywire are the best places to get an objective opinion of how good a fund manager is.

Is the manager earning enough return for the risk he is taking?

Some fund managers simply buy companies they think are cheap based on the evidence available in the balance sheet on its cash flow, its debt or its forecast earnings. Doing this is time consuming and hard work and most active managers hold far less than the all the shares in the market. That means they are taking more risk than just that of the asset class. The amount of risk the fund is taking can be measured by the tracking error. A good fund can be identified because it will have a high alpha and beta of more than one no matter what its tracking error is. That means it is taking more risks than the market and is getting a better return. As tracking error goes up so should the alpha. Dividing the alpha, the extra return, by the tracking error, the extra risk, gives us the information ratio. That tells us if the fund is getting enough extra reward to compensate for the extra risks it is taking. You can find these data on the Trustnet website.

How accurate are labels?

The Munro Fund only holds UK stocks and it sits in the UK All Companies Sector where the primary objective is capital growth. You might think that any fund labelled as a UK fund would only hold shares in UK listed companies. In fact that is not the case. Under the Investment Managers Association rules that determine which category a fund is placed in it is possible for a fund to hold up to 20% of its portfolio in foreign stocks. That is not a problem as long as investors know that some of the return from such as fund will come from asset allocation and not stock selection. In other words the fund may benefit, or suffer, from the beta of a foreign stock exchange. Clearly, such a fund will have a different risk profile to one, such as The Munro Fund, that is confined to UK stocks only.

How consistent is the manager?

Unfortunately, history shows that some managers are good in some conditions, like a rising market, and others are good in different conditions, perhaps one that is falling for a while. And there is no one to tell you if we are in rising or falling markets, or one where technology shares or commodity shares are the place to be. What is important is to be invested in the market to catch the good days. Timing the market does not work.

Choosing a manager is much harder than choosing a share and there is whole sub-industry dedicated to it. Considering that 66% of managers underperform their benchmark, i.e. have negative alpha, in any three year period the job is quite important. Even if they do match or beat the index then it is important to consider how much risk, measured by the tracking error, it has incurred to achieve that return. If a fund took more risk than it received in performance it will have a negative information ratio. Few active funds have consistently positive information ratios.

This excellent letter to the Financial Times details the odds against choosing a marker beating fund. In it the writer says there was a 5% chance of picking one of the 9 out of 177 actively managed stocks that beat the index between 2000 and November 2008. The argument made by a fund of fund manager that it is easier to beat the market by choosing the right funds for the prevailing conditions is demolished by proving that there was only a 3.5% chance of achieving better returns than the market. And that is before consideration of risk and costs.

How loyal is the manager?

 

But there is another problem. Fund managers are not, on the whole, terribly loyal and half of them change jobs every five years. According to the UK Fund Industry Review and Directory 2005 only 43% of fund managers have run their fund for 4 years or more. So even if you find a good one the chances that he or she will be there after two decades is less than 6%. Keeping an eye on all these managers is an important part of the selection process.

What about index funds?

So if choosing an active fund manager is not easy are index funds that you can buy and forget a better option? It is certainly true that the bulk of your returns come from making the right choice of assets rather than selecting the best stocks.

A memorable piece of research in 1986 found that only 5% of an investor's return came from that compared with 92% from being in the right asset class. But buying a fund that ignores all the research being done by analysts seems to be admitting defeat. Besides the stock market any given time could be in love with a particular sector as it was with technology in 1999. That can distort valuations and index funds are forced to buy companies simply because everyone else is. Index funds, or passive trackers, reflect what is popular, or unpopular and do the opposite of what we do when we go shopping. If we see cabbages have fallen in price compared to sprouts we will tend to buy more of them.

The opposite happens with an index fund. New money going into such a fund will be allocated in favour of the larger companies at the expense of smaller companies as defined by market capitalisation; which is the share price multiplied by the number of shares. That might, or might not, be justified by the size of the profits companies make as we saw during the "tech bubble" at the turn of the century. There is no simple link between the size of the company and the profits it makes.

A new alternative

We think there is a better way of constructing a portfolio that avoids the problems of traditional and active funds. One that uses hard data and not the opinions of others to determine how much of each stock to hold. We call it a Fundamental Tracker.

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