How to choose a fund manager

Instead, he chooses specialist managers and firms from around the world, and then matches complementary mandates. So, for instance, within an equities-oriented fund, he’ll hire one manager focused on Canadian equities, another on U.S. equities and a third on emerging markets.

Beyond geographic expertise, he’ll diversify based on managers’ styles, philosophies, volatility strategies and tactical approaches. Above all, he looks for consistency, since any style drift could jeopardize a portfolio’s construction.

To do this, he and his team need a robust process for picking PMs and monitoring their progress — he shares it with Advisor’s Edge Report.

How do you measure consistency?

If a manager’s supposed to do well in down markets, we verify she’s done well in those environments. But if she consistently also does well in up markets, that would raise a flag because she’d be participating the wrong way. She might be chasing returns.

Make sure to look at how managers react to difficult times. If you talk to them and they don’t look panicked, that’s a good sign. They might even be adding to positions.

We spend a lot of time with our managers. One group meets with them regularly; that’s its sole job. And my team meets with managers quarterly, so we have two layers of meetings.

What warning signs do you look for?

A lot of turnover in the organization. Whether the manager has brought people on who don’t fit with the culture. Grumblings about compensation. Rumours about the manager being sold to a bigger entity or peer — the change could be positive, so we examine how it would affect the manager.

These signs would appear before performance starts to lag.

We also look at team dynamics within a management firm. If we’re in a meeting, and the analyst keeps looking to the PM for assurance that he’s not saying anything wrong, that means it’s not a healthy relationship.

Chances are the analyst’s ideas aren’t going to get into the portfolio unless the PM likes them. But the analyst can’t be scared to bring those ideas forward. He’s spending day in, day out on each name. In many cases he knows the industry better than the PM.

Watch for performance over a market cycle, but know that sometimes the cycle is longer or shorter than four years. You have to give the manager enough time for the ideas to follow through. And remember, performance is a lagging indicator.

What would make you fire a manager?

When we hire managers, we also lay out reasons to fire them. Unsatisfactory performance is one, but there are also qualitative factors: if we bought the organization for a key person, and that person leaves without them bringing anyone else on board, we would terminate that relationship.

Before hiring, we ask ourselves, “What do we like about this growth manager?” Say that person is known for consistently capturing the upside and lagging with the downside while not giving it all up. If that expectation doesn’t play out in a real-life market situation, we’d fire that manager.

We also want to see that the team gets built out as AUM rises. If not, it’s a sign that down the road people could get overworked, and that could hurt performance.

You should expect 10% to 20% manager turnover each year, because you find other investment themes to pursue or you find better managers. And for every manager, we have a backup in the wings.

How much do you monitor those backups?

Same as the main managers; sometimes it turns out the backup is a better candidate. We don’t just replace when things aren’t working; we’re also always looking for candidates that might be better than what we currently have.

For the same amount of risk, we might be getting better reward, or for the same amount of reward, we’re taking less risk. Both of those situations are upgrades.

How do you match managers?

We make sure their correlations are relatively low. That removes the unrewarded risk.

The best value and growth managers don’t necessarily complement each other. If you have quant and fundamental managers, that’s a good mix. They’re not going to get dinged the same way. It’s not just value matched with growth, it’s also matching investment styles: fundamental with technical; macro with bottom up. We may also diversify among firms.

We then run scenarios looking at past performance of managers X and Y to see how they would have fared together. Are we protecting what we think we’re protecting? If not, ask the PM if it was an anomaly, or something more.

But when you look to the past, make sure you’re evaluating the same PM that’s in place now.

We also look at turnover rates: both within the company and within the manager’s stock selection, depending on mandate. A defensive manager will hold names longer because they were bought at discount and need the market to come around.

Some growth managers will buy small positions because they’re high-risk, high-reward — growth will be very high in the beginning. But as soon as they hit their targeted rewards, you want them out of those names, because you usually expect lower growth going forward.

Do managers make adjustments for each other?

No. I tell each manager, “I’ve hired you for your mandate only.” We make the adjustments instead.

We know when managers are going to underperform, so when a tough period for one of them comes, I say, “This isn’t going to be an environment you’re going to do well in. We’ll take some money off the table and give it to manager Y. When market dynamics shift back in your favour, we’ll bring the money back. And if the environment really favours you, I might even bring more back.”

Because they understand that dynamic, no one’s worried AUM will be cut.

What questions should advisors ask managers?

Ask when they do well and when they don’t. Advisors tend to fire managers at the wrong times. If you fired someone right after 2008, you probably sold her because of a market event, not because of anything she did.

If someone says he does well in every environment, he’s not the right manager.

Ask, “What sort of stocks are you buying? Are you a high volatility manager?”

If it’s a key person, ask what succession plan is in place. Ask, “How long do you plan to be around for? Who else is behind the scenes?”

For returns, ask, “Are you focused on a benchmark, absolute return, or comparison to other managers?” I don’t want managers thinking about the competition.

If they focus on benchmarks, chances are they aren’t going to take many bets, so don’t expect major over or underperformance. If they focus on absolute returns, all they’re trying to do is make sure they keep their heads above water.

They may not necessarily shoot the lights out — they may not buy high-flying stocks because they already hit their positive return targets. But in a tough market environment they’ll do pretty well.

Melissa Shin is managing editor of Advisor Group.