It has been an incredibly ugly period for funds management in recent months, albeit a very informative one for their investors. Unfortunately, the market environment is transitioning, and in response many fund managers have – simply put – been found wanting. It is exactly this type of period when manager weaknesses and strengths are more easily identified. The challenges to active management are an under-recognised and very significant problem right now for many portfolios, but a crucial one for investors and their advisers to urgently address.
The good news is that manager selection - in some ways - just got a lot easier (which makes for a nice change - as it is rarely easy or simple). Close inspection often reveals that many fund managers have underperformed by being in crowded trades, or have shown neglect of the broader investment environment (it is hard to see the ocean when you’re a fish!). Far too often a manager claims of being ‘defensive’ in down markets has been discredited. This has provided fund selectors with very useful insight to help screen out prospective offerings!
Investors now have strong reasons to rotate to managers who provide more aligned and “true to label” offerings. We now have a new relatively simple way to search for fund managers that are genuinely adding value and doing what they said they would, simply by closely considering their performance in 2018. Of course, 2018 should not be the only factor which is considered, and some individual manager underperformances are understandable (on a case by case basis) - not every poorly performing manager in a portfolio needs to be removed!
The bad news – and this is indeed bad news - is that so few managers did well in 2018 that it is now difficult to construct an entire portfolio of proven performers! This is why it is crucial to ensure portfolio management considers the true to label outperformers and the relatively scarce genuinely value adding managers in 2018 as first-line building blocks.
It is important to remember that active management has many potential benefits in these markets, including the provision of genuine and absolutely critical diversification to mainstream asset class exposures. Implementation with the right managers is the key to capturing these benefits in practice. In particular, outperforming and diversifying alternatives managers are incredibly useful right now as portfolio building blocks.
Simply put, when looking for new fund managers investors should now be really interested in how they performed in late 2018, and why they performed as they did. Attribution and questioning of the manager – along with a simultaneous understanding of the market conditions from a factor and style performance point of view – will help provide these answers. Is our manager genuinely market neutral, or do they simply provide hidden market exposure? Late 2018 provides us with some very important information in this regard, being a substantial stress test of current markets at the latter end of a long bull market and structural global asset bubble. Watch out for modest long-term return prospects and frightening tail risks!
Too often, generic research on fund managers fails to consider the obvious, in particular a few basic but crucial factors which could greatly improve its usefulness for investors and portfolio construction. Three simple examples of routinely neglected factors to consider before one can fully consider an individual manager for a portfolio include:
1. What are the objectives for our portfolio and for our manager exposures?
We should target managers that are aligned with our portfolio objectives and those which provide a useful role for our portfolios in that context. For example, if we want absolute returns and not relative returns, it makes a lot of sense to consider absolute return and market neutral managers who have similar targets and are working towards the same goals - and which can invest in cash as required! If we are sceptical that managers will live up to their promise of outperformance and don’t want to pay for mediocre performance, then we can first consider managers which are strongly aligned to us by having limited capacity and which are only paid via performance fees. I’d suggest full credit is deserved by managers like Harvest Lane and EGP Capital for providing these offerings to market. (Disclosure: Procapital is an authorised representative of Harvest Lane Capital Pty Ltd.)
2. To fully understand a fund manager’s prospects, we need to understand the broader investment environment and the possible outcomes for the markets it operates in.
This helps us select managers that have tailwinds rather than headwinds. Indeed, contrary to common knowledge, often manager outperformance is driven more by market tailwinds and disciplined investment process than it is by manager skill. For example, if merger and acquisition activity is likely to be high because economic growth is low and companies need to source growth, it is quite likely a merger arbitrage manager will do well. In contrast, if credit is expensive and has large headwinds, even a good long only credit manager may make a poor investment proposition.
3. We should understand the degree of competition in the manager’s strategy.
You can be a skilled fund manager, but if your competition is plentiful and also skilled, your likelihood of outperformance is low and chances are your asset class is crowded. In general, it is sensible to prioritise more niche alternative strategies (where they are few managers of their type) than heavily competed and more crowded and well known active strategies. These niche alternative strategies not only provide more prospective returns, but correlation and diversification benefits also.
It is obviously critically important to ensure that beyond consideration of individual managers, your overall portfolio has an adequate balance of risks and is genuinely diversified. This is a challenging task in today’s markets where the outlook is highly challenging and many asset classes are being driven by common risk factors, making them even riskier in a portfolio context than they otherwise would be. Frankly, the knowledge, experience, insight and time required to build portfolios well is not widely dispersed and is rarely found in your typical financial advisor alone.
Fortunately, there are now numerous boutique investment consultants – many with extensive investment experience - helping financial advisers build better portfolios. It is important to understand whether those advising on money are actually backed up by expert investors (at a portfolio and fund selection level) with the investment skills and knowledge to make effective decisions at the whole of portfolio level. An individual fund manager usually does not make an ideal portfolio by itself, but a carefully chosen selection of asset classes and fund managers may, and hence the potential value add at the whole of portfolio level is much greater than it is at the individual fund level. Simply put, many advisers need to outsource or increase their use of portfolio construction and fund selection expertise if they are going to increase the quality of investment proposition they provide for their clients in this highly challenging investment environment.
For more insight on fund manager performance, portfolio construction, and the investment challenges of today, please refer to my previous posts.
Jerome Lander is Managing Director of boutique investment firm Procapital and an Authorised Representative of Harvest Lane Capital Pty Limited AFSL No. 425334, which manages the Harvest Lane Absolute Return Fund. This communication is for informational purposes only and is a thought piece which represents the views of the author alone. It is not intended as an offer for the purchase or sale of any financial instrument. It does not constitute personal or formal advice of any kind and should not be relied upon as such – investors should consult their financial advisers before making any investment decision. This article’s accuracy cannot be assured. All opinions and views expressed constitute judgment as of the date of writing and may change at any time without notice and without obligation.