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. 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 as measured by its market capitalisation, 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 doing this is experience and some estimate for what may happen. This can be things like oil prices going up by more than others think or having more faith in a company’s new product or strategy. Tracking the performance of fund managers is a full time job and Bestinvest is one of the best places to get an objective opinion of how good a fund manager is.

Is the manager earning more return for the risks 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 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. 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.

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. 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. No wonder index funds that you can buy and forget have a strong appeal. 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 like it was with technology in 1999. That can distort valuations and index funds are forced to buy companies simply because everyone else is. There must be a better way. And we think there is and it is called a Fundamental Tracker.

 

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