How do you choose underlying funds if you are a multi-manager?

Greg Flash of PSG Asset Management writes that when investing in stocks, some investment managers believe that meeting management is critical to understanding and investing in a company, while others believe that it confuses the investment process and that company reports are all that is needed from management.

As multi-managers, we believe that it is crucial to meet and get to know the fund managers that we invest with. There are no globally accepted rules about multi-management or investing in other fund managers. There is no Graham and Dodd version of “Security Analysis” for multi-management. There are no balance sheets or income statements to study, all there is, is the fund manager and their historical performance.

When investing in stocks there are some golden rules that if followed, will most likely result in a positive outcome for an investor in the long term. The two most taught and quoted (but not always followed) are to buy assets when they are cheap and sell assets when they are expensive. The problem comes when one invests in funds rather than stocks. Open-ended funds/unit trusts/mutual funds do not have explicit measures of value. They don’t have stated Price to Book, Price to Earnings or Price to Cash Flow ratios. It is therefore nonsensical to look to buy “cheap” funds and sell “expensive” funds.

So how do we as multi-managers decide on which managers to invest with? The simple answer is that we follow a set of rules – an investment process – that we have developed over the years. The process entails a quantitative aspect and a qualitative aspect. The quantitative aspect is based solely on historical data, specifically returns and risk measures. We use the recognised ratios and measures as well as our own in-house developed tools to screen and filter the funds in our universe.

The quantitative side is important because it essentially narrows the field of possible funds and focuses us on the group of funds that we will then do a more in-depth analysis of. The more critical aspect of our process is the qualitative side. This is where the manager is assessed.

In a company, when there is a change in management, this does not necessarily result in a change in how the company is run. The workforce and products often remain largely the same, and hence profitability will often be largely unaffected. In comparison, a fund (unit trust or hedge fund) does not have a workforce or products; it only has the fund management.

Hence when the portfolio manager of a fund is changed, almost always the investment process of a fund will change (even if this is unintentional). In the majority of cases this results in the style of the fund changing and hence a change in its performance profile. It is therefore more accurate to say that one invests with a manager, rather than in a fund. As a multi-manager it is essential to not only meet fund managers, but it really does help to get to know them as best as possible. The choice of the right manager is critical to the long term performance of one’s investment. Reading about a manager is acceptable, but meeting and interacting with a manager is first prize.

As stated previously, the quantitative side of our process looks at historical returns and risks. If a fund has a long track record with the current fund manager, the historical performance is useful and gives some indication of what the manager is capable of. However, this track record still is not a predictor of future performance. We believe that a good assessment of a manager is far more indicative of what their future performance is likely to be.

The question then arises: “How do we assess a manager?”

We start the process by having all prospective managers complete a detailed due diligence questionnaire. Much of the questionnaire deals with the management company’s details as well as the more static information about the fund manager, such as qualifications, years with the company and years managing the fund. This information is important to check and record because it forms the basis of our compliance check.

The second part of the qualitative analysis involves a visit with the portfolio manager at their offices. We can then physically verify that there is more to the company than simply the marketing people and the fund manager. A good due diligence meeting involves not only the fund manager, but also contact with some of the analysts and the back office personnel. Essentially, these on-site visits give us a feel for the work environment and interactions between role players.

At a due diligence meeting we try to rate the manager according to five criteria: investment philosophy and process; risk management; knowledge base; systems; and team dynamics and motivation. Although this is a subjective process we assign ratings to each of these criteria. This rating system is useful for a couple of reasons. Firstly by “measuring” these criteria, managers can be ranked and recorded for comparison with other managers. Secondly, the ranking helps when more than one person from our team visits a manager. In discussing the manager, we can have a more productive conversation about the meeting, rather than remarking simply to one another “well, he was pretty good, wasn’t he?”

We always remember one thing when we meet with a manager – to look beyond the presentation. The presentation has very little to do with the skill and quality of the portfolio manager. Great managers do not need to present often, their performance sells itself. Obviously a great presentation does not mean the opposite, but we are careful to not get bowled over by a very slick presentation.

A profit or loss is only made when one sells an investment, so when do we sell our managers?

We do not sell our managers based on bad short term performance. We know that manager performance goes up and down based on their investment style, the point in the current investment cycle and the manager’s investment horizon. By blending different managers who have different performance profiles together, we try to smooth out the short term performance volatility. Unlike investing in a stock, where one usually sells when the stock price has reached full value or higher and is more likely to decline rather than increase, a top performing manager can remain at the top (or at least above average) perpetually. The likely cause of poor medium to long term performance is a change in the criteria that we initially assessed them on. Hence we continue to monitor these criteria throughout our investment with them. If there are changes to any of them, we will make a critical analysis and re-rank the criteria. The one alarm bell that will most likely cause us to sell out of a manager is a change in the manager or management team.

Investment management houses make every effort to smooth over departures of managers, but we remain very sceptical of performance continuity with a change in management. The new manager is unlikely to be a clone of the previous manager and even if they are part of a team, there will be differences. Therefore when a manager change occurs we will conduct a new due diligence afresh, acknowledging that the performance track record of the fund has now been reset back to zero.

Multi-management is just that, investment in a multitude of managers and although our products are named funds of funds, we are investing with managers and not in funds. Although there are no formal rules for multi-management, we believe that the process that we have developed over time to be robust and beneficial to our investors.

The PSG Angle is an electronic newsletter of PSG Asset Management. To subscribe or read more, please go to www.psgam.co.za.