Traditional Managers

Investing is easy. I just buy a stock and hold it ‘til it goes up. If it don't go up, I don't buy it.

—Will Rogers

It's almost impossible to express how difficult it is to identify truly outstanding portfolio managers in time to profit by investing with them. By truly outstanding, I mean managers whose outperformance relative to the broad markets and to other managers will be so great as to result in significant wealth creation for their investors. Consider that since 1970 several thousand Americans have won large lotteries—lotteries large enough to result in significant wealth for their winners. But since 1970, how many Warren Buffetts have there been? More than one, to be sure. But not thousands. Not hundreds. Not even dozens. Statisticians will tell us that playing the lottery is a fool's game,³ that in the aggregate lottery players lose far, far more money than they win, and that even the remote possibility of gaining great winnings doesn't begin to justify the cost of playing. What would statisticians tell us about the challenge of finding outstanding money managers?

And if identifying great managers weren't difficult enough, timing in the enterprise is everything. People who invested with the legendary hedge fund manager Julian Robertson early in the game had little idea how much money they were about to make. But people who invested with Robertson late in the game had little idea how much money they were about to lose. Same great manager, very different outcomes.

Finally, outperformance among managers tends to show little persistence over time, at least if we define outperformance to mean “consistently landing in the top quartile of all similar managers.” Not long ago Greycourt looked at persistence even among managers in a sector of the market that is generally considered to be inefficient, and where talented managers should have room to run—namely, small-cap managers.

We prepared an analysis using a group of 57 small-cap growth managers and compared relative performance over time. Most investors believe that capable managers should be able to add value in inefficient sectors with reasonable consistency over time. Hence, the purpose of the exercise was to determine how often managers remained outstanding performers over time. Our analysis illustrates the difficulty managers face in maintaining their top performance rating over even relatively short periods of time. Of the top 15 managers at the beginning of the study, only two remained in the top 15 eight years later. On the other hand, the manager who finished dead last (57th) at the beginning was the 11th-rated manager by the end. In other words, investors hiring any of the top performers identified at the beginning of our study would have been sorely disappointed.

The Main Problem: Recent Good Performance Is Almost Irrelevant

The main mistake investors make in engaging managers is hiring a firm that has experienced good recent performance—say, a better-than-average five-year track record. The reason this is a mistake is that, more often than not, a good five-year track record says virtually nothing about how the manager is likely to perform over the next five years. That track record might indicate that the manager will continue its outperformance, but it is far more likely that the track record indicates one of the following:

Characteristics of Best-in-Class Managers

It is, alas, not possible to define the characteristics of best-in-class managers in a way that is detailed enough to enable investors to apply a simple template and see if the manager fits it or not. Too much judgment and experience are involved. Nonetheless, the main characteristics of best-in-class managers are simple enough to state. They are as follows:

• Investment philosophy. The quality of a portfolio manager's investment philosophy is perhaps the single most critical element in judging whether the manager is likely to be capable of sustained outperformance. Unfortunately, this issue is also likely to be of little help to individual investors in identifying best-in-class managers. The reason is that there is no such thing as a money manager who can't articulate an investment philosophy that sounds good. The only way to know whether or not what sounds good actually holds any water is to put the manager through a thorough, multilevel scrutiny, ending with an intensive on-site grilling of the manager and its senior team by an investment professional who has had vast experience interviewing and working with managers.
• Discipline. Even the most solid investment philosophy won't create wealth unless it is implemented in a disciplined manner. To determine whether the manager is a disciplined investor and is sticking to its philosophy in good times and bad, it is necessary to conduct a detailed review of the manager's performance during periods when the wind has been at its back and when the wind has been in its face. Attribution analysis and a close examination of investment decisions that turned out badly can shed important light on these questions. In particular, sell discipline—strict rules that determine when a security is to be sold—is important. As noted above, sell discipline tended to disappear during the bull market of the 1980s and 1990s. Under more normal market conditions, however, sell discipline is crucial. Otherwise, managers will tend to hold appreciated securities far too long and to believe that they are “smarter than the market,” therefore holding on to underperforming securities that should be sold.
• Experience. Any manager can outperform over a short period of time, and investors who hire such managers after that period of outperformance will almost always—almost always—be disappointed. The five-year rule is intended to enable investors to observe a manager's performance over a full market cycle, that is, a period of time during which the manager's investment style and philosophy are in vogue as well as a period of time when they are out of fashion. Hence, five years might be too short a period of time or, in a few cases, it might be more time than we need.
• Asset base. Some investment philosophies and styles can be carried on at huge scale, but others will be successful only if they remain niche businesses. Bond managers can oversee tens of billions of dollars with relative ease. Indeed, scale matters in bond management because trading costs, especially the costs of trading municipal bonds, can eat up a large fraction of the potential returns. But small-cap managers face the opposite problem: The float of most small-cap stocks can be very thin, making the management of even a few hundreds of millions of dollars problematic. Many professionals believe that trading costs are so high with smaller stocks that any return advantage is completely negated. Thus, with small-cap stocks smaller really is better all around.
• Alignment of interests. Money management is a business, and like any business operator, money managers will attempt to maximize their profits. If those profits can only be maximized by acting in the interests of clients, the manager-client relationship is likely to be satisfactory to both parties. Unfortunately, there are many ways in which money managers can increase their profits at the expense of client investment returns. One obvious example is for the manager to emphasize asset gathering over alpha generation. It is far easier for a manager to increase its fee revenue by focusing on proven sales techniques than by focusing on the complex challenges associated with investment outperformance. As a result, most money management firms are really sales organizations, not money management organizations, and are to be avoided on that ground alone.⁵ The general practice of charging asset-based fees is also problematic. If the manager's results are poor, the manager's fee declines but he still gets paid; the client, on the other hand, has lost real money.
• Organizational stability. A sound investment philosophy can only be implemented by an investment team that has worked together for years and that has experienced little, if any, turnover. Even among managers who have produced outstanding long-term track records, organizational instability is an excellent early warning sign that performance is likely to deteriorate. The same is true of asset management firms that have recently been purchased—this is almost always a sure sign of bad things to come.
• Quality of the client base. This may seem an odd characteristic to focus on, but in fact the quality of a manager's client base can make an important difference in the manager's ability to function with minimal interference and maximum stability. Typically, managers who have performed competently over the course of many years, but who are never (or rarely) the best-performing managers in any year, will wind up with a stable, sophisticated client base that understands what the manager is doing and that will be patient with periods of underperformance. Managers who have shot the lights out now and then, followed by periods of very poor performance, will tend to wind up with a client base consisting mainly of unsophisticated, “hot money” clients. It is virtually impossible for a manager to operate sensibly if clients are constantly pouring money into the firm and then pulling it out again.
• Personal integrity. This should go without saying. Although it may seem harsh, any blemishes on a manager's record should disqualify the firm from serious consideration. This includes regulatory problems at the firm level and also personal problems at the individual level.
• Trust—but verify. President Reagan, during the SALT negotiations, was fond of saying, “Trust—but verify.” The same is true of managers. It is always interesting to hear a manager talk about its style, but a returns-based style attribution analysis rarely exaggerates. The professionals at a firm may appear to be the very soul of rectitude, but a background check will result in far fewer sleepless nights for investors. Broadly speaking, substantial families have no choice but to place their capital at risk. But narrowly speaking, substantial families never have to place their capital with any particular manager. Before we entrust our capital to a manager, we should always trust—but verify.

Objectionable Characteristics

In addition to the useful characteristics of managers just discussed, it's also important to look for the presence or absence of objectionable characteristics in asset management firms, such as a focus on asset gathering, a weak trading or back office operation, a predominance of inexperienced personnel, a bureaucratic organizational framework, a history of regulatory problems, an organization that is primarily engaged in activities other than money management, and so on. The presence of even one of these objectionable characteristics should raise an immediate alarm, requiring further investigation, and the presence of two or more should send investors running in the other direction.⁶

Finding Best-in-Class Managers

There are many ways to go about the process of finding the best managers, but I like the three-stage process we use at my firm, Greycourt & Co., Inc. It works generally like this.

The early phases of this process rely largely on quantitative screening and evaluation criteria, whereas later stages are almost entirely qualitative in nature. Our ultimate goal is not to identify which managers have outperformed in the past—any fool with a computer can do that. Rather, our objective is to identify the reasons why selected managers have outperformed in the past and to judge whether those reasons are likely to persist into the future.

The first step (Level I) in our due-diligence process requires managers to be measured against a series of six objective criteria. These criteria vary somewhat from asset class to asset class but generally are as follows:

We use these screening criteria in two ways. First, the Level I screen allows us to quickly determine if we should spend our limited time meeting with salespeople seeking to introduce us to their products. Second, the Level I screen allows us to efficiently comb through publicly available manager databases such as Morningstar, PSN, and HFR to see if there are potentially interesting managers that we may not yet have knowledge of. It is important to note, however, that many of the managers we use or are interested in do not always pass all six of our Level I criteria. For example, we are often interested in concentrated equity managers who have low R-squared statistics but who otherwise are excellent. We have the discretion (which we use often) to pursue further research on any manager, whether or not they pass all six Level I criteria. Finally, though the Level I screening process works well for most long-only asset classes, it is somewhat less useful in evaluating alternative asset classes such as private equity, real estate, hedge funds, and so on.

The next step (Level II) in our manager process involves gathering as much information as possible about a potentially interesting manager. Initially, our information-gathering focuses on further screening out inappropriate managers. For example, we seek to determine if a manager is closed to new assets, whether they have reasonable minimum account sizes, whether their fees are competitive, what kinds of investment vehicles they offer (separate accounts, limited partnerships, mutual funds, etc.), or whether they have unusually high turnover which may cause them to be tax inefficient. These additional early Level II questions do not take much time to complete and often weed out another 25 percent to 50 percent of the managers who made it past the Level I process.

Once the list of qualified manager candidates has been narrowed, we seek to gather a broad array of information about each manager in order to formulate an opinion on how they were able to generate attractive results in the past. The type of information typically acquired includes:

• Manager pitch books
• A live manager presentation
• A completed Greycourt Manager Questionnaire
• The manager's Form ADV
• Relevant Web news and articles about the manager
• Comprehensive style-based return attribution analysis

All information gathered is immediately recorded in Greycourt's proprietary manager database so that it becomes instantly available to each of our investment professionals. We view our ability to access all manager information on a timely basis as critical to our ability to deliver high-quality and consistent advice to our clients.

Once we have evaluated all of a manager's information, a Greycourt investment analyst will prepare a brief two-page profile summarizing the manager's key attributes. At the same time, a Greycourt partner will begin to formulate an initial opinion (referred to internally as our Investment Thesis) seeking to articulate concisely why we believe the manager in question has succeeded in generating superior results in the past.

The third phase of our evaluation (Level III) is the most important and also the most qualitative. The objective of our Level III analysis is to attempt to validate the preliminary Investment Thesis established during the earlier Level II review. During this final phase, one or more of Greycourt's managing directors will meet with the senior members of the candidate manager's firm, usually in their offices. At these meetings we seek to better understand the manager's investment philosophy, risk controls, tax sensitivity, organizational structure, incentive compensation plans, operating infrastructure, compliance efforts, and interpersonal dynamics.

Our Level III efforts culminate in a peer review in which the sponsoring partner articulates, in writing, his or her view of the candidate manager's differential advantages; comments on the sustainability of those advantages; and identifies potential risk factors that might invalidate the perceived sustainable advantage. Partnerwide conference calls are held every week to discuss candidate managers who have completed all three levels of review. Very often the Level III peer review call results in additional questions being raised or further information being requested. Assuming that all additional questions are satisfactorily addressed, a formal vote is conducted in which all partners either approve or reject the candidate manager for inclusion on Greycourt's recommended list.

Monitoring Best-in-Class Managers

Once approved, we seek to monitor approved managers' continuing quality in several ways. First, we generate a report that measures the difference between each manager's monthly return and its relevant benchmark (this difference is referred to as tracking error). We then compare that month's tracking error to the manager's five–year historical tracking error. To the extent that a manager's tracking error in any given month is +/−1 standard deviation away from its historical tracking error, we initiate a call to the manager. During these calls we will ask them to describe what factor(s) caused them to perform unusually well or unusually poorly that month. Their responses are recorded in our database. Simply as a result of this monthly review process, we will, on average, speak to our managers three times per year. Our second form of review is to formally reevaluate each approved manager on an annual basis in order to reaffirm our belief in our stated Investment Thesis.

When one of our managers experiences a change of control, acquires another firm, or suffers the loss of a key portfolio manager, we immediately seek to understand how these changes may affect our stated Investment Thesis. The urgency with which we reexamine a manager undergoing a change depends on that manager's inherent volatility. For example, the departure of a key professional at a municipal bond manager is less alarming than the departure of a key professional in a small-cap growth firm. We seek to quantify our view of each manager's inherent risk by developing a numerical risk measure on each manager used. Developing this numerical assessment of manager risk is a regular part of our Level III analysis. Also, as noted earlier, part of our Level III review is to articulate specific risk factors that may invalidate our Investment Thesis. If one of those identified risks becomes a reality (such as a key professional's departure) we will fully reexamine the manager.

Managers are rarely terminated for poor performance alone. We terminate managers when it is deemed that they no longer maintain the differential advantages that caused us to hire them in the first place. Examples of reasons that have prompted us to terminate managers in the past include:

• Departure of a critical investment professional(s)
• Significant style drift
• Failure to limit asset growth to levels promised
• Failure to communicate or be responsive to requests for information

Obviously, this approach to identifying best-in-class managers will be far beyond the capabilities of most individual families. And there is nothing sacrosanct about the way Greycourt goes about the process. However, if your financial advisors aren't following something like the process as described above, perhaps you're working with the wrong advisors.

Active, Indexed, Fundamental, and Structured Products

When it comes to marketable securities, investors have a wide choice of strategies. Thus, wholly aside from the question of whether it is possible to identify outperforming managers in advance, investors have other arrows in their quiver as they attempt to achieve solid performance.

Active Management

An active manager owns a basket of securities that is different from the index he is being measured against. If he is successful, his securities will outperform those of the index by a sufficient margin to overcome the drag of his fees, trading costs, and taxes. As noted above, there are “closet” index managers who charge active management fees, and these folks should in general be avoided, as they are bringing little to the party. By contrast, there are managers who own a basket of securities that is very different from the index, giving them a real chance to outperform and earn their keep—but also giving them a real chance of underperforming dramatically.

In fact, most good active managers will both outperform and underperform dramatically over the course of time. Consider Bob Rodriguez, the best-performing mutual fund manager of the last quarter century. Rodgriguez runs the FPA Capital Fund, and typically owns no more than 30 stocks, despite the fact that he is being measured against the S&P 500 index. Despite the fact that he is the single best manager in the Morningstar universe, very few investors have benefitted from the extraordinary record of FPA.

In the late 1990s, for example, Rodriguez refused to play the tech game, and underperformed dramatically. His asset base was cut by more than half as investors left in droves. Again in 2005–2007, Rodriguez hated the market and underperformed again, resulting in more than $700 million of redemptions.⁷

Thus, in addition to the problem of trying to identify managers like Rodriguez in advance, there is the behavioral problem of sticking with the manager through thick and thin—something most investors don't have the stomach for.

Index Management

A passive manager—think the Vanguard 500 Index Fund—simply tries to replicate the exact performance of the index it is measured against. This won't always be done by owning all the stock in the index, because mimicking the index performance can sometimes be managed in less expensive ways. Depending on how liquid the index is, tracking error can often be a problem, but with large indexes like the S&P 500, tracking error is minimal. By buying a well-managed index fund, you are guaranteeing that you will get the return of the index, less a small fee. You are also guaranteeing that you won't get any outperformance, of course.

Indexing tends to result in low turnover (and hence low trading costs) and also in lower taxes than active management, unless the active manager is extremely tax aware or trades very infrequently.

The problem with passive investing is that most indexes are capitalization weighted—in other words, if Google represents more of the index than, say, Johnson & Johnson, the index fund will own more Google. This is swell if you believe in momentum investing, but all too often it ends up causing you to buy high and sell low. Hence the interest in fundamental investing.

Fundamental Management

Fundamental investing is a version of passive investing, but it has characteristics of active investing as well. A fundamental index fund will not be capitalization weighted, but will select its securities with reference to other, more economically fundamental, factors; for example, sales, earnings, book value, cash flow, and dividends. Many of the products offered by firms like Dimensional Fund Advisors (DFA) are fundamentally weighted rather than capitalization weighted.

Because fundamental characteristics change slowly over time, fundamental investing tends to be less volatile than index investing. This can be good and bad, of course. If we are in the middle of a raging bull market and the S&P 500 is up 40 percent for the year, your friends in the cap-weighted index fund will also be up about 40 percent. But there you sit, wallowing in your fundamental index fund, up only 22 percent. What you are likely to do is to dump the fundamental index and plunge into the cap-weighted index, just as it's about to crash.

By their nature, fundamental indexes tend to have a smaller cap and value tilt versus cap-weighted indexes. This is good if you are a value investor and believe in the “small-cap effect,” but it can hurt when value and small cap are out of vogue, as in the 1990s.

Finally, fees tend to be higher in fundamental index funds, so you will need to be confident that that's what you want.

Structured Products

Fundamental indexes are a kind of structured product, but there are other ways to create structured investments—for example, by equally weighting all the securities or by creating a rules-based portfolio. The rules might have to do with the liquidity and fairness of emerging markets exchanges, for example, or the quality of financial reports by companies.

A structured portfolio takes no position on the merits of individual securities, but instead seeks to outperform by adhering to certain rules, including rebalancing. Some studies have shown that an equal-weighted portfolio would have significantly outperformed a cap-weighted portfolio over the last 45 years,⁸ primarily by avoiding the individual security concentrations that result over time in a cap-weighted portfolio. Rigorous rebalancing in these portfolios tends to result—over time—in the sale of appreciated securities (selling high) and the purchase of less highly appreciated securities (buying low).

The volatility of structured portfolios can vary widely, depending on cross correlations in the target market. For example, the volatility of a structured portfolio focused on U.S. equity markets will tend to be higher than the volatility of a U.S. equity cap-weighted index. On the other hand, the volatility of structured portfolios focused on emerging markets, currencies, or commodities tends to be lower than cap-weighted indexes.