People often make decisions based on the information being presented to them, or whatever information they have easy access (while then, on top of that, overlaying their own behavioral biases). As it relates to fund manager selection, this information is, in most instances, insufficient for making an informed decision.
As an advisor, an important part of your relationship with the plan sponsor is assisting them with plan investments. Whether you accomplish this in-house, use a third-party manager, or rely on the plan recordkeeper’s reporting, we recommend revisiting your process for selecting funds.
Let’s dig a little deeper.
The number of mutual funds in the United States has hovered around 8,000 for the past couple of decades but for the sake of simplicity, we’ll assume that you have been asked to make a choice between two managers from the same asset class. e.g. US growth stocks.
What is your plan? Do you have a process? Is your process effective?
With most decisions the limiting resources are time and money. How much time do you have to make the choice? How much money can you allocate to collecting data and research? Answers to these questions will determine how much of a plan or process you have.
I would venture to guess that, like most of us, you have limited amounts of both. Those limitations often translate into a process for manager selection that is limited to a simple trailing-performance and fee comparison.
I would suggest that is not much of a process. Especially when the fine print is telling us that historical performance is no guarantee of future performance, and a simple fee comparison alone cannot paint the whole picture.
So, what can you do? What else should you be considering when comparing two fund managers?
A proper due-diligence examination should start at the organizational level. A qualitative analysis of the organization will provide you the framework to understand the managers, how their teams operate, and where they might face challenges and shortfalls. This is hard to do, though, and it comes with a cost. This line of questioning requires a healthy dose of skepticism and will lead to an understanding of how people within the organizations make decisions and could highlight major differences between the two managers.
Who are the decision makers and how are they incentivized?
Various types of organizations employ various types of decision makers. Portfolio managers and their teams often earn additional compensation in the form of fund performance-based bonuses. However, short-term incentives can lead to unnecessary risk taking and volatile and inconsistent performance. Long-term incentives can lead to “closet indexing” (when actively managed portfolios are not much different than that of their benchmark). Other types of additional compensation, such as ownership in the fund or ownership in the organization are also common, each with their own pros and cons. Team member location and research style also have an impact in the management ecosystem, it’s important to think through how communication is affected by a team being in the same room, same floor, same building, or across the country, etc. Other questions around employee training, tenure, and turnover can reveal differences between the two managers as well.
Various types of decision makers and styles lead to various types of fund management. At face value, these two managers may describe what they do very similarly, but it is more important to know how they implement it.
Where do the managers claim to source their performance? Is it through stock selection? Is it through sector exposure?
The important thing is that an analysis of the returns reveals that they are achieving their returns where they claim to be skillful. What do they claim gives them an edge? What is the manager’s competitive advantage? How has this process changed over time? How much of the funds historical track record has been managed this way? Many funds in the same asset class have very similar holdings, what part of their process makes them unique? As a follow up, is that uniqueness sustainable? Will the inefficiency they are claiming expertise at exploiting persist? Does it make sense to you? It is also important to compare the universes from which the managers are selecting companies. There are many different indexes, even within the same asset class. Therefore, managers within the same asset class may not be using the same index as a benchmark. A comparison between the managers benchmarks and investment strategies are required to determine whether the managers are selecting companies from the same universe.
Do these managers differ in how they manage risk in their portfolios? What are the guidelines for sector exposure and individual position sizes? How many holdings are in the portfolio? Do the managers keep a cash position in the fund?
Understanding the differences between the two managers’ organizations and management practices will give a good context in which to examine the funds expense ratios. Is it commensurate with the amount of work being done and is the amount of work being done commensurate with the performance of the fund? The additional fee an active manager charges above an index fund should ideally be more than made up for in risk-adjusted outperformance relative to the funds benchmark.
The result of your due diligence process should be an opinion of the fund that stems from an understanding of the organization, how the people in that organization operate, how the fund is managed, and if the fund is achieving its stated goals.