May, 2009
The Second Opinion: ManagerSEARCH (Part One)
ManagerSEARCH (Part One)
Since the beginning of the recent economic slowdown, and the accompanying dismal stock market performance, investors have been asking many questions of their advisors and investment managers. In many cases it becomes evident that as the markets boomed, driven by ultra-volatile commodities, the managers became lax in their risk management. They found it easy to overweight equities instead of rebalancing, thereby (temporarily) looking like a genius as markets rallied.
In some cases the issues can be worked out with better communication between the client and advisor/manager. However, in many other cases the advisor/manager should be fired and the investor should begin the process of finding a replacement.
With this in mind, Second Opinion Vice President Ken Hawkins has put together a two part series on our proprietary ManagerSEARCH™ process. The focus is on selecting an investment manager based upon what Mr. Hawkins has termed The Four P’s - People, Philosophy, Process, and Performance. Understanding these four principles will empower you to better assess investment professionals.
In addition to that, we present Warren MacKenzie’s tip, “Understand your advisor’s investment strategy”. It should be noted that the term “advisor” in the tip can be also be applied to include discretionary money managers.
By Carlo Palazzo, CIM
Understand Your Advisor's Investment Strategy
Why this is important: Most investors do not have a strategy that they follow consistently in both up markets and down markets. Yet the most important element in ensuring investing success is having the discipline to stick with the chosen investment strategy.
Does your financial advisor have a well-reasoned investment philosophy that is suited to your needs? You should not assume that every financial advisor follows an investment strategy that makes sense for your portfolio.
Every advisor has an investment strategy of some kind. In the worst case, it might involve “churning” the client’s account to make the highest possible fees. Other bad strategies include: switching investments to what is hot at the moment; buying based on recommendations made on TV stock market shows; buying all of the brokerage firm’s current choices, or all the new issues; or buying on hunches and the belief that the advisor can beat the market.
The point is to understand the strategy and stick with it through different market and economic cycles. Many strategies will work well. The key to success in almost every case is to stay with the strategy through the bad times as well as the good.
Alarms should go off in your head if your financial advisor is unable to explain his investment strategy in terms that you can understand. The bells are telling you that it may be time to switch to a new advisor.
An advisor who has a strategy has thought things through and knows why certain investments are purchased at certain times. He has a plan that looks forward and anticipates changes. Beware of the advisor who is prone to go with his emotions. Buying and selling securities based on emotion is a sure way to lose capital.
Bottom line: Your financial advisor should have a well-thought-out investment strategy that can be explained in terms a lay person can understand.
What you can do now: Get an explanation of your financial advisor’s investment strategy and an opinion on why it is the best strategy for you. Make sure you find out how the proposed plan will be useful in minimizing risk for the expected return. Make sure you understand how the strategy is expected to work in good markets and bad.
Process and Philosophy
The process of finding a professional money manager is the same whether you want the manager to manage the entire portfolio or only a portion of it. Because a money manager that is appropriate for one person may not be appropriate for another, you need to determine your individual requirements and the specific attributes of different managers in order to find the best fit.
Every individual has a different set of requirements, but each would be based on the following factors:
- Psychological and financial capacity for risk
- Amount of investable assets
- Tax issues
- Specific investment objectives
- Personal preferences
- Liquidity requirements
- Investment constraints
Likewise, every manager will have a unique set of attributes which can be summarized by the 4 P’s:
- People – includes the overall organization, but specifically those who make the investment decisions
- Philosophy – investment philosophy and strategies of the firm as it relates to making investment decisions and managing money
- Process – the processes the firm uses to ensure that the investment strategies, communication, and client service are properly implemented
- Performance - historical returns on their investment portfolios
In this article we will concentrate on the first of the two P’s (People and Philosophy) and in the second installment next month we will discuss the other two (Process and Performance).
People and Organization
The first consideration is the quality and stability of the investment team. Each key employee should be highly skilled, with substantial relevant experience and education. They should work well together, and ideally have demonstrated this through at least one market cycle. They should be committed to their clients and their firm.
The ownership structure of the organization is also important. If this has changed recently, or is likely to change in the future, this could have implications for clients. In general, investment professionals who have ownership in their firm are likely to have a greater commitment to its success than salaried employees.
Differences between large firms and small firms
Money management firms vary in size from single practitioners to large corporations with thousands of employees. There is no research that concludes that large firms outperform small firms or vice versa, however there are advantages and disadvantages of each that can be important to individual investors.
Large firms typically have well-established processes in place, research capabilities in-house, established risk-management systems, capabilities to invest in many asset classes, and a greater breadth of expertise. If they lose a couple key people it is unlikely to affect clients. They tend to make decisions by committee, and consequently the investment views might converge to the consensus views of the market, with resulting performance that mirrors the market. Typically larger firms cannot act as quickly as smaller firms as the investment landscape changes. Also, the clients of large firms usually don’t have close ties with, or even access to, the key decision makers.
Small firms typically have limited systems and few resources. They tend to be more specialized in their approach and have limited or no expertise in some asset classes, especially global investing. If one or two key people leave the firm it can have a major impact on clients. However, with fewer decision makers, small firms can be more nimble, enabling them to react quickly to changes in the investing environment. Furthermore, clients can typically get better access to those managing their assets.
Philosophy and Investment Strategies
The investment philosophy of a firm is their set of beliefs that will determine their approach to managing money. It is generally based on capital market theory and supported by research. The philosophy should be well articulated and there should be evidence that the manager consistently applies the philosophy through various market conditions. The validity of the philosophy should be empirically verified.
Each manager will have a specific style or strategy when it comes to selecting securities for both fixed income and equities. For equities the main styles are based on growth or value as well as based on the size of the company, i.e. small or large capitalization. Fixed-income investing will have its own strategies.
Each manager will also have a specific philosophy for setting and changing a portfolio’s asset mix. The asset mix decision is considered by many to be the most important investment decision. There are two components to the asset mix decision. The first component concerns itself with the long term or strategic asset allocation. The second component will refer to either a rebalancing or a tactical asset allocation strategy which will change the asset mix of the portfolio to take advantage of near term views on the markets.
Active Versus Passive Investing
All investment strategies can be classified as either active or passive.
Active managers believe that they can add value to a portfolio by picking securities that will, on average, outperform the market. Active management is the predominant form of money management today and most mutual funds would be considered to be actively managed. Because active management involves higher management fees, managers not only have to outperform the market, but they also have to outperform it after fees and costs are deducted.
Passive investment management assumes that it is very difficult to outperform the market. Rather than try to “beat the market,” managers match the market and do so as cheaply as possible. It is called passive investing because managers do not make decisions about which securities to buy and sell. They simply mirror the index. The advantage of passive management is that it is much less expensive to manage investments and the cost savings are passed on to the investors.
Active and passive investing applies to both security selection and asset allocation. So there are actually four general philosophies that investment managers will fall under:
Passive Asset Allocation, Passive Security Selection
This is the simplest of all strategies. The manager has determined a long-term or strategic asset mix that is appropriate for the client. The asset mix is rebalanced occasionally to ensure that the long-term asset allocation is maintained. Index funds or ETFs are purchased to represent the underlying asset classes.
Active Asset Allocation, Passive Security Selection
In this strategy the managers will adjust their asset mix depending on their overall views of the markets. If they believe that stocks are going to outperform in the short term, then they might overweight the equity asset class in their portfolio. Another name for active asset allocation is tactical asset allocation. Index funds or ETFs are purchased to represent the underlying asset classes.
Passive Asset Allocation, Active Security Selection
The manager will have a long-term or strategic asset mix, which is rebalanced occasionally to ensure that the long-term asset allocation is maintained. For each asset class, individual securities are purchased in the belief that the manager will outperform the stock market using their skills in stock selection. These managers believe they cannot add value using tactical asset allocation.
Active Asset Allocation, Active Security Selection
In this strategy, the manager adjusts the asset mix depending on their overall views of the markets. If they believe that stocks are going to outperform in the short term, they might overweight the equity asset class in their portfolio. For each asset class, they purchase individual securities, with the belief that they will beat the market.
Stock Selection Strategies
There are many stock strategies that the managers will employ. Most managers will adhere to one specific strategy or style, although large managers might use different strategies for different investment pools. Most styles are classified as either value or growth. Managers using a value strategy believe they can select stocks that trade for less than their current intrinsic value. Growth managers believe they can find stocks that have superior growth characteristics that the market has undervalued. When the future growth is realized the stocks will go up. Each type of strategy will have their proponents. Any logical strategy that is followed is always better than no strategy. The value is in the disciplined approach a strategy provides. There are many different investment strategies including:
- Growth Investing
- Value Investing
- Small Cap Investing
- Income
- Momentum
- Sector rotation
- Theme-based investing
Bond Strategies
Bonds are simpler than stocks as there are only three factors to consider: duration, credit quality, and the future direction of interest rates.
Duration strategies are based on the expectation of changes in interest rates. If an investor believes that interest rates will rise he will shorten the duration of his bond portfolio by selling bonds with long term maturities and buying bonds with short term maturities. If he believes that rates will fall he will do the opposite.
There are many strategies based on bond quality, such as high yield bonds and strategies based on changing risk premiums. As an example, the yield spread between corporate bonds and government bonds is higher in a recession than when the economy is strong.
Each strategy has its strengths and weaknesses, its advocates and its critics. Sometimes one strategy will be superior over another one. The net result is that one style is not necessarily superior to another but different styles will have different performance and risk characteristics. The important thing is that there is discipline in ensuring that the strategy is followed.
Ken Hawkins
