One of the most common questions from our investors is which other fund managers we would recommend. While we normally decline to talk about specific people, we are happy to discuss our experience on the structural differences across investment mandates, organisational structures and performance fees. In our view, the two most important aspects when assessing a fund manager are ability and willingness. That is:
Does the manager have a sustainable ability to outperform the market, and
Does the manager have the willingness to share this outperformance with its investors?
7 questions to assess their ability:
The ability to outperform the crowd comes from focused people doing things differently. Stock picking is part art, part science. The art part depends on someone’s personality and life experience, while the science part relies on doing the hard work and follow a proven investment process.
Some of the questions we found useful to explore are:
1: Does the investment mandate provide the tools to achieve an investment objective and its performance fee potential in different parts of a market cycle?
Most fund managers claim that preservation of capital is the priority. We have not yet come across a fund saying risk-taking is more important than capital preservation.
However, most funds do not have the flexibility in their investment mandates to actually preserve capital. If a fund can have a maximum of 10% cash and is not able to hedge using derivatives, then there is no way this fund can preserve capital in a severe market decline.
The correct claim of these funds should be to outperform a particular market index and rely on the assumptions that the market index does capital preservation over the long term. (This is an assumption, not a fact, as shown in history that the equity markets often produce zero real return over more than a decade, especially from the top of a market cycle).
Note that for a fund with a relative fee structure, it can still charge a performance fee even when it declines significantly.
2: How is the portfolio constructed differently from the benchmark?
Two keywords here are 'differently' and 'benchmark'. While a diversified portfolio may have lower stock-specific risks, it also makes it closer to the equity index and harder to outperform.
If the benchmark is independent to an equity index, such as an interest rate plus a hurdle, then this portfolio will likely behave very differently from an equity index, with the potential to outperform or underperform materially.
3: How is the manager’s investment process different from peers?
In modern-day investing, information asymmetry has been reduced significantly, allowing everyone to invest based on similar information. Unless a manager does things differently, such as through a particular insight, different thought process or deeper focus on a specific industry, it is very hard to break away from the peers.
4: What is the manager’s plan to manage the fund’s capacity due to inflow and compounding?
Every investment strategy has an optimal capacity band where it provides the highest percentage investment return. The rule of thumb is that for a successful fund, the money will be flooding in after three years of good performance, and most funds will be over its optimal capacity after five years of good performance.
For a fund to continue to do well, having a strategy to manage the drag of more capital is vital. Warren Buffett does not become the richest investor in the world by returning his capital every few years, but the compounding of an ever-larger capital base does.
5: Are the manager’s investment philosophy and style consistent with its ownership structure, incentive structure, team structure and fund capacity?
Different investment philosophy and style require different business constructs to do well. For example, if a fund manager’s style is to trade a lot (as sometimes evidenced from consistently high year-end distribution), then the corresponding optimal construct is a small FUM, higher emphasis on individual incentive and more reliance on broker friends. Any deviation from the optimal would mean the fund is heading for a different direction that deserves more questioning.
6: Is the manager’s track record consistent with what they are doing? Is the track record in a representative period of the market?
While past performance is not indicative of future performance, a good track record does mean a fund manager did something right in the past. However, a track record is not useful if the fund manager is doing something different.
For example, we have experience investing in Australian micro cap, small cap and mid cap with a market cap range of $50m to $10,000m. We can confidently say that they require very different approaches to do well and it takes a number of years to adjust from one group of stocks to another group of stocks.
Certain investment styles do better in a different part of the cycle. Currently, growth has outperformed value, but it will revert in the future. If a high-performing manager’s portfolio mainly consists of hyper-growth stocks in the late stage of a bull market, be careful about extrapolating the recent performance into the future.
7: Are stock research, decision making and responsibility being diluted from having too many people in an investment team?
One of the least known secrets in funds management is its scalability. The number of investment professionals required in a fund is dictated by the investment style/strategy, not the size of the FUM.
How many investment staff is needed to manage a $1B small-cap portfolio? Two.
How many investment staff is needed to manage a $700B asset pool, consisting of public equity, private companies and insurance/derivatives liabilities? Two (Warren Buffett & Charlie Munger).
5 questions to assess their willingness
While it is always good to have a great moneymaker looking after your asset, it is essential that this person actually wants to share the spoils with you.
1: What are the motivations behind a portfolio manager to succeed?
The only wrong answer is money. While the thirst for money can propel one to do well in the short term, the lust is lost over the long term as most of the successful fund managers will make more money than they can spend.
If a fund manager is honest about this answer, then think carefully about any potential misalignments between this motivation and your investment objective. Certain motivations, for example, the goal to build the most successful fund management business in Australia, means that you should probably invest in their business, not their funds.
2: Is the incentive structure aligned with the investment objective and your need?
If a manager knows the incentive structure is not aligned but he claims to possess an above-average ability to do the right thing regardless, run away immediately. Every man is the product of his incentive, only a liar is the exception. If a manager is incentivised to beat an index that has gone into the bubble territory, you know he is highly likely to be allocating money into speculative assets.
3: Do the manager’s actions spell respect and fairness when performance is good and fundraising is no longer needed?
We think investors are our partners in business and they deserve respect and fair treatment. The best way to determine whether a fund manager is respectful and acting fairly is to see what they do when performance is good and they no longer need to raise fresh equity due to full capacity.
For a fund manager in their maximum bargaining position due to recent success, the only power investors have is to take money out. If the fund manager takes this power away by locking in the money permanently without compensating the investors accordingly, such as a fee reduction, it is hard to argue about fairness and respect.
Make no mistake, most fund managers do not run as a charity, they have no obligations to treat the investors well. However, investors can do much better if they can find a good fund manager that also treat investors fairly and respectfully.
4: Does the manager keep its promise on fund capacity?
Raising more money can be addictive to a fund manager. Not only does it increase income, but it can also elevate one’s status from a bigger asset base. Keeping fund capacity limited is the best way to assess a fund manager’s willingness to share his investment skill with the investors.
Raising additional money is also very useful before a bear market. The inside jokes on money raisings are:
"If the market is going to decline by 50%, let’s double the FUM now so it can halve to the original size"! and,
"The portfolio is stuck in illiquid positions and we need more cash, so let’s raise 30% FUM to increase cash to 30%"!
Another way to bypass a capacity promise is to launch a new fund based on a slightly different mandate but managed by the same people, preferably owning substantially the same stocks but with a much bigger capacity.
5: Does the performance fee construct take into account the risks being taken?
Typically a long-only equity fund charges performance fee when exceeding a market index. If we use this as the base case, then a strategy that takes more risk, such as short-selling (which increases stock selection risk), and with leverage, should have higher performance fee hurdle. Be aware arguments that say short-selling actually reduces the “risk” in the portfolio so the fee hurdle should be lower.
So, who do we recommend?
Which other fund managers would we recommend? The first filter is someone who has managed money through at least one bear market. Unfortunately, not many of the “smart” and “star” fund managers you hear about in the past few years have actually lived through a bear market in the same fund they are managing now (including your author at MX Capital).
We will defer answering this question until after the next crash. But by that time you would probably have the answer already!
What an a very refreshing article and one that is very insightful and honest. I have never read an article that hauls fund managers over the coals and this was very insightful. All fund managers should read it and answer where they sit.
Well done on the article!