17 Sep People Matter – Part One
From James Purvis, member of the PHAROS Investment Committee
People plus Process produce Portfolios plus Performance.
Most of the PHAROS Investment Committee attended the recent Portfolio Construction Conference. This annual event usually has a theme and this year it was “The Long and the Short of It”. As usual, many of the presentations that were relevant to the overarching theme were given by leading fund managers, most of them active fund managers. “Active” usually refers to the attempt to engage in activity that adds value versus a benchmark or index by holding a portfolio that is unlike the composition of the benchmark. Active does not necessarily mean a lot of activity in buying or selling securities within the portfolio, although this can sometimes be the case as well.
As we have said previously in these pages, the regular yearly reports such as SPIVA from Standard and Poors, note that between 60% and 80% of active fund managers underperform their index fund counterparts. Indeed, one of the more active fund managers presenting, Chris Joye, of Smarter Money Investments, gave a compelling presentation that highlighted how over 90% of active fixed interest managers underperform the index after fees, compared with only about two-thirds of active equity managers. He went on to show how some active fixed interest fund managers can and do add value.
Another leading presenter, Professor Ron Bird of the University of Technology Sydney, gave a cogent exposition of why many active fund managers fail to add value. He outlined how in relation to equities management, one-third of market participants are index followers, not trying to add value, one-third are using a momentum based approach and one-third are using a fundamental or value based approach. He concluded that this market composition was an important part of why equity markets are not efficient and why all of the information is not yet in the prices. He also indicated that the evidence suggests that some momentum managers, following a well-defined process, add value, as do some fundamental managers,which rely not only on a sound process but on the skills and experience of the people driving it.
Many investors (and advisers) want to believe that they can select active fund managers that can persistently add value. In most cases they also want to believe that the key individuals are critical to success. Not all of them turn out to be messiahs. The PHAROS Investment Committee uses a rigorous quantitative screening process to help select a group of active fund managers in each asset class that will have performance that is persistently better than the benchmark indices. To do so from a pool of candidates where less than a third beat the benchmarks is a formidable challenge. Numbers alone will not give the answer. In addition to the quantitative screening process the PIC employs a method of evaluating the factors, which produce portfolios that have good performance over time.
In short People plus Process produce Portfolios plus Performance.
The method that the PIC employs uses independent research ratings of People and Process where these are available as well as an interview process that focuses on the same explanatory factors. Over many years and many fund managers it has become clear that most active managers rely on a relatively small number of key individuals for persistent performance. The number is usually one or two, sometimes as many as three or four, but rarely more. This applies to large established firms with over $40 billion of funds under management as well as to relatively new or start-up firms managing just a few million.
If something significant happens to one or more of the individuals who are key to the portfolio composition then the use of the fund manager needs to be re-evaluated even if there has been no deterioration in the performance that has yet shown up in the quantitative analysis. Such events can (and have) included:
Disputes with colleagues
In other words, the usual vicissitudes of life. All of these have happened in recent years to funds that have had Approved status on the APL
The key to managing these risks to future performance is to have a monitoring process and an ability to exit the fund at short notice.
This article has been mainly about the importance of people at the fund management level. Next time we will look at the importance of key people to events in financial markets and the impact that this can have on asset allocation.