Finding the elusive 0.5% in investment management
Our Best of breed™ approach affords us the privileged position of meeting and partnering with some of the world’s most accomplished investment managers. We also get to meet many that don’t quite cut the mustard.
In our experience, the key to finding a great manager is to focus on the 0.5% that differentiates them from the rest, rather than focusing on the 99.5% they will have in common with most other competent managers. Just like in top level sporting endeavours, as highlighted in the article by Dr Ross Tucker, this seemingly minuscule 0.5% difference can make all the difference.
When one interacts with an asset management firm, the interaction often takes the form of a standardised and somewhat formal ‘due diligence’ presentation that will extensively detail the investment philosophy and process of the firm in question. These presentations usually follow a predictable format and include references to any combination of the following: an organogram on group structure, value investing, margin of safety, detailed research, Warren Buffet quotes, committee meetings, experienced employees - the list goes on. These meetings are usually passive in nature; in other words you listen to what the manager thinks you want to hear. Rarely will such an interaction provide unique insights into the firm or its people. In summary, these meetings can only take care of the 99.5%; the hygiene factors.
To find the elusive 0.5%, deeper research is required. Inferences need to be corroborated and supporting evidence found. At best, this takes significant time and effort; at worst it is impossible if managers are unwilling or unable to provide what is required.
One of the surest ways a manager can allow you to really get ‘under the bonnet’ is by writing regular, comprehensive, well thought out investment commentaries. Going back through the annals and comparing what they were saying when, and how that manifested in portfolio positioning and ultimately results, can hugely enhance your understanding. The degree of conviction and the candidness of the communication when performance is not good can be especially insightful
Unfortunately, the vast majority of managers miss out on this opportunity to allow their investors to really understand what they do in practice. This is disingenuous because the better the client understands the manager, the more likely the client is to remain invested through inevitable periods of underperformance.
Ask open-ended questions
The approach of asking managers to explain certain things about their business and beliefs – without the use of any supporting material – can also enable a deeper understanding. Asking open-ended questions and giving managers the space to answer as they see fit often elicits perspectives that would otherwise be missed in a formal presentation. For example, asking the question ‘Why will this business still be around in 20 years’ time?’ will give a sense of what the manager thinks are the most important factors (and the relative importance of each) for creating and maintaining a successful investment management business. Different businesses provide very different answers, and there is no right or wrong one. But you should be able to make a judgement on how much thought and effort has gone into creating structures that can stand the test of time. Also, take note of whether managers talk naturally and easily about their responsibility to investors. We find that there is a direct correlation between how seriously a manager takes their responsibility to clients and eventual client outcomes.
Or ask something along the lines of: ‘what is risk and how do you construct portfolios to be robust in any of the (many possible) outcomes?’ The answer to this will give insight into how every aspect of their process and philosophy pulls together in execution. In our view, the very best managers display a healthy respect for what they do, don’t and can’t know, and have clearly thought out mechanisms to protect their portfolios against these ‘unknowns’.
Another way to garner insight is to ask not about a particular stock but rather about an industry in which a particular company operates. Industry dynamics can be critical to the investment outcome, and these types of questions will enable you to see how deep the research has gone. Do they understand the capital cycle and where in the cycle an industry currently finds itself? What sources of information do they use to form their view? A manager that can reference industry periodicals or interactions with customers, service providers, competitors and industry experts will be easily distinguishable. One of our manager partners has gone as far as employing a Pulitzer Prize nominated journalist to assist in this process.
We are forever asking managers what they think about other managers. Recognition and respect of one’s peer group is often the hardest earned and most deserved. Over the years we have established an ‘insider’s view’ of who is highly rated by their peers. We also talk to ex-employees and long-existing investors.
Consider track records in context
When we interact with managers for the first time, we try to go in with an open mind and therefore limit our analysis of their track records as far as possible. This is because a good track record will still look good after you ‘slice it and dice it’ but will probably serve only to make everything the manager says more credible. In other words, it will bias you from the outset.
When the time does come to analyse the track record, it needs to be properly scrutinised. Not so much to see if they are good (because let’s face it, no one ever appoints a manager that does not have a good track record). Rather, one needs to establish if the track record is worth paying any attention to at all. Are the same people implementing the same process and philosophy under the same conditions? More often than not, the answer is ‘no’ and the track record should be disregarded.
Perhaps the most challenging aspect of finding an outstanding investment manager is not so much about figuring out whether or not they have a reliable approach that has been well implemented. With enough effort, this is achievable. The difficult part is figuring out whether they will be able to repeat what they have done in the past over the next market cycle. And you won’t find the answer to this question in the 99.5% presentation. You will need to find it by digging deeper.