Developing best practices in dealing with underperformance
Why do managers get fired?
Reasons vary from mandate breaches or a change in the investor's objectives, to operational issues with the manager, or even excessive increases in fees charged. Performance is only one of many factors.
A change in management
Manager changes form one of the more significant costs within an investment strategy. In fact, most investors who make hiring and firing decisions tend to make them at the worst possible time, firing underperforming managers just before they have a good run and hiring outperforming managers about to enter a lull in performance.
Investors need to be careful to differentiate between skill in a manager and good past performance. A 2011 study by Towers Watson concluded that only 20% of managers that have strong past performance are skilled managers. The study recommends that investors should rather downplay the importance of past performance and focus on reliable drivers of future excess returns.
How did we get to termination?
Ambachtsheer's book Pension Fund Excellence noted 'poor process in terms of decision making, investment policy setting and communication' as the primary source of failure in retirement funds. Respondents cited this 98% of the time as opposed to the failure of fund managers and suppliers, which was cited only 5% of the time.
Putting in place an appropriate structure to reach decisions and communicate those decisions is crucial. Key factors investors should consider include:
This will outline the principles based on which the investor makes decisions (e.g. how to deal with socially responsible investments or conflicts of interest or when termination is considered)
- Setting objectives
An investor without objectives is like driving at night without the lights on - you can't see where you're going
- Setting asset allocations
Studies have concluded that asset allocation is a significant determinant of an investor's long-term results. Investors also need to consider what strategy to take within each asset class that is aligned to their beliefs about investing
- Selecting managers
Manager selection is far down in the process, but equally deserves an allocation of resources to ensure optimal results
- Appropriate monitoring and communication
It is important for investors to keep track of how their strategy is doing and to effectively communicate to relevant stakeholders
Selection of managers should take into account reliable drivers of future excess returns, the manager's philosophy, research and investment process, people and culture. An analysis of past performance allows an assessment of whether results are consistent with the manager's stated approach.
Appropriate monitoring of selected managers ensures that the reasons for selecting them remain in place, and the investment results they are producing are consistent with their stated approach. Investors should do this within the context of the investment strategy, allowing managers sufficient time to prove their ability.
Ticking all the boxes
Once investors have reached the stage of reviewing a manager for termination, they need to consider the classic firing mistakes. In a 1996 paper titled "Hiring and firing managers - part luck, part art, part science", John Ilkiw identified these as:
- evaluating managers independently of an established strategy, and
- delaying firing because of good performance
To this, we can add dealing with behavioural factors such as regret aversion and overconfidence, which can contribute to or exacerbate firing mistakes.
Investors need to keep some key elements at the forefront of their decision:
- Evaluate your manager in the context of the reasons for hiring. Even with underperformance, is the manager still fulfilling the designated role within the broader investment strategy?
- Be aware of behavioural influences. If there are operational concerns with a manager, avoid delaying decisions until the operational issues result in poor performance
- Obtain expert advice. The Myners Review of 2002 suggested investors seek appropriate advice where necessary. Studies have shown that consultants can add value to decisions on manager hiring and firing through their extensive research
Dealing with underperformance on its own raises the question of how long investors should tolerate this before making a decision, given that sometimes a good manager will have periods of underperformance. At these times, it is prudent for investors to have interim measures to ensure they apply sufficient time and focus to decisions. Interim measures may include:
- Withholding future cash-flows to the manager in the strategy
- Reducing the weight of the manager in the strategy
- Seeking temporary fee reductions until performance improves
Firing your manager should be the last step in the process
It may seem obvious, but firing your manager should be the last step in the process. If investors ensure that they have a robust investments framework within which they make decisions, and they understand the challenge that making the firing decision carries with it, they will have gone a long way to ensuring that they carry out their duties with the necessary care, skill and diligence.
Investor handbooks do not advocate value destruction, and investors should be careful not to erroneously achieve this in their own strategies. Underperformance is a concern for any investor and this article is not suggesting that investors should avoid firing managers. However, investors should ensure they apply themselves to the matter in a methodical manner.