June, 2009
The Second Opinion: ManagerSEARCH (Part Two)

Welcome New Team

In an historic month for Second Opinion, in order to keep up with the growing demand for our services, we have added five new associates to the team. Perhaps the message is finally getting out—advisors who get paid solely by commissions cannot escape the inherent conflict of interest that exists in the financial industry. For truly unbiased advice, an investor must turn to a true fee-only advisor who only gets paid by the client and receives no referral fees or hidden fees from major “product” companies (such as mutual fund or insurance companies).

With Ken’s articles from this month and last discussing his process for evaluating managers, an investor can likely do a reasonable job of evaluating investment managers/advisors. However, first one must find an advisor/manager to meet and work with. There are countless online directories and tools, but we suggest three good places for an investor to look for advisors/managers:

Note that the first two are for financial advisors while the last one is for discretionary money managers.

Of course, one may not have the time to do a thorough evaluation of many different managers or advisors. In this case, Second Opinion’s proprietary ManagerSEARCH™ service is extremely valuable.

The ManagerSEARCH™ service evaluates managers against what Ken Hawkins has termed the Four P’s—People, Philosophy, Process, and Performance. It should be noted up front that by ‘Performance’ we really mean performance against a reasonable benchmark. To get an idea of what a reasonable benchmark is, read Warren’s tip ‘Use the Right Benchmark to Measure Performance’.

By Carlo Palazzo, CIM

Use the right benchmark to measure performance

Why this is important: If you don’t have the proper tool to measure performance, a performance problem may persist. Your benchmark is the level of performance that you and your advisor agree is necessary and achievable. This is your tool for measuring and monitoring investment performance.

Recognizing a problem with your investment account is the first step on the road to correcting the situation. The problem can’t be fixed until it is identified. You also need a standard of measurement to discover the problem’s size and nature. This standard is the benchmark: the performance level that you and your advisor agree should be expected from your investment portfolio. The benchmark describes the expected average return and also the expected range of returns for the portfolio. For example, the return benchmark might be an average of 8% over five years, and the range-of-return benchmark might be between -5% and +15%. Comparing your performance against the wrong benchmark may lead you to think you are doing well when, in fact, you are doing very poorly.

From a financial advisor’s point of view, the oldest trick in the book is to make a client feel good by comparing performance with the wrong benchmark. To avoid this problem, you and your advisor should agree in advance on how performance will be measured and what reference points will be used in making comparisons. When the advisor agrees to use a specific benchmark, several good things will follow:

  • The advisor will be accountable for results.
  • Underperformance can be seen clearly.
  • Whether or not the portfolio has underperformed can be determined without an emotional confrontation.
  • The advisor will have an incentive to keep fees low because performance numbers will be reduced by the amount of fees charged.
  • The existing asset mix will be reassessed for its efficiency.
  • The financial advisor is on notice that there will be no fudging of results.

The way to put these steps in place is by using an Investment Policy Statement. Not having an agreed upon benchmark creates several problems. For example, assume you have an investment portfolio made up of 50% Canadian common stocks and 50% government bonds. Your account statements show that over the past three years, your return averaged 3% per annum. You tell your financial advisor that your instincts tell you that with this asset mix you should be doing much better.

Your financial advisor is shocked and explains that you have in fact done very well. As evidence, he points out that over the past five years the Toronto stock market has been down by 10%, NASDAQ by 30%, and the emerging market index by 20%. He explains that, since markets are down by an average of 20%, his efforts have resulted in your earning at least a 23% improvement over the average return in the equity markets. If you accept this line of reasoning, you are being seriously misled. Consider:

  • You are not 100% invested in the equity markets, so the comparison is misleading. Let’s say your portfolio is a blend of 50% Canadian stocks and 50% Canadian government bonds. The performance benchmark, therefore, should be based on the average of these two specific indexes, not just one unrelated type of index.
  • You are not invested in NASDAQ or the emerging markets index so the performance of these markets is irrelevant.
  • The advisor has compared your three-year return with the five-year return on the various indexes. Not only should he use the proper index but you also must use identical time periods. Comparisons are always misleading when they are not for precisely the same period.

The foregoing is an example of a “relative return” benchmark for judging the performance of a financial advisor or investment manager. Here, you are comparing your return against the external benchmark that you and your advisor have agreed is the proper one. (The benchmark should be agreed upon in advance, not after the fact.)

However, another yardstick, the “absolute return,” is even more important. This yardstick is the rate of return you need to earn to reach your financial goals.

You should be aware of how actual performance compares against both benchmarks.

On a relative return basis, if you lose 12% but the benchmark lost 20%, you might (in theory) feel satisfied because you “beat the benchmark.” The reality, however, is that investors don’t like to lose money - even if they have lost less than the benchmark index. With an absolute return benchmark, if you need to earn 10% to achieve your goals, you want a portfolio designed to earn 10% on average.

You don’t care what happens in the stock market, you only care that you are earning, on average, the rate of return you need.

You should understand, however, that even with an absolute return benchmark of, say, 8%, you are not going to earn 8% every year without fail. If your plan calls for an average return of 8%, your actual return in any given year almost always will be either higher or lower than the long-term average. You should know the expected range of returns for your portfolio and you should always be within the expected range of returns regardless of what happens to the market in a particular year.

Bottom line: Don’t let your financial advisor make bad or mediocre performance look good by comparing your performance results against the wrong benchmark. Agreeing in advance to the use of the proper benchmarks usually will prevent arguments about performance levels. A relative return benchmark is used to judge your financial advisor’s performance while an absolute return benchmark tells you if you are on track to achieve your financial goals.

What you can do now: Talk to your financial advisor and get her agreement on the benchmark that will be used to judge performance.

Process and Performance

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. Each manager will have a unique set of attributes which can be summarized by the 4 P’s:

  1. People – includes the overall organization, but specifically those who make the investment decisions
  2. Philosophy – investment philosophy and strategies of the firm as it relates to making investment decisions and managing money
  3. Process – the processes the firm uses to ensure that the investment strategies, communication, and client service are properly implemented
  4. Performance - historical returns on their investment portfolios

In last month’s article we concentrated on the first of the two P’s (People and Philosophy) and in the second installment this month we will discuss the other two (Process and Performance).

Process

An investment manager’s process can be broken down into two distinct parts. The first part is the process that will ensure that the firm’s investment philosophy will get implemented in a consistent manner resulting in an investment portfolio that will reflect the firm’s underlying philosophy. The second part is the process to ensure that the portfolio is managed properly and in an efficient manner. Each money manager will have a different implementation process and some might be more appropriate for some clients than others.

Focused Versus Broadly Diversified Portfolios

A big difference among managers is the type of portfolios they will construct. The smaller, traditional portfolio managers tend to be stock pickers. They typically will have focused portfolios of 30 to 40 securities when you include bonds. Some of the smaller managers will predominately use ETFs and they will have broadly-diversified portfolios. The larger firms might use pooled funds or a combination of pooled funds and individual securities to broadly-diversify portfolios. Compared to broadly-diversified portfolios, focused portfolios are:

  • More volatile
  • More likely to outperform as well as underperform
  • Easier to understand
  • More likely to have fewer asset and sub asset classes

Customized Versus Massed Produced Portfolios

Some managers are able to create customized solutions for their individual clients. They can incorporate existing stock holdings into the portfolio or design the portfolio based on very specific requirements the client might have. Others will have a few choices based on general investment objectives and risk tolerances such as income, balanced or growth that are available to each client. The client will be put into a portfolio that will be very similar to other clients with similar goals. For many investors customization is not an issue, but for others it will be necessary to provide a better investment solution.

Segregated Versus Pooled Accounts

There are two different account structures; segregated and pooled funds. With segregated accounts the investor owns the securities directly in his or her portfolio. Pooled funds are very similar to mutual funds; you do not own the securities directly but own a partial interest in a fund. Segregated accounts can be more customized with more flexibility for incorporating tax strategies. Pooled funds might have lower fees with typically broader-diversification than segregated accounts.

Client Relationships

There are essentially two different types of client relationships. In one case, the client deals directly with the portfolio manager – the individual who is making the investment decisions for the client’s portfolio. The other case is that the client will deal with a relationship manager who in many cases is totally removed from the investment decision making. Investors who want to be closer to the decision making might prefer to deal with a portfolio manager rather than a relationship manager.

Fees

Fees will include management fees, but might also include custodial fees, trading fees and performance fees. It is important for an investor to understand the fees that are charged in the running of their portfolio.

Fees are usually calculated as a percentage of assets under management, subject to a dollar minimum. All other things being equal, lower fees are better. An investor seeking strictly to minimize fees should employ index funds. If active management is desired, fees will be substantially higher, but the fund has at least a reasonable chance of outperforming the index. Some firms will have a performance-based fee, or sliding scale wherein the firm participates in the profits of the investor. The use of performance fees can provide an additional incentive for managers to add value. However, it can result in a manager taking excessive levels of risk, so they can maximize their own fees.

Investment Performance

The most obvious thing to look at when choosing an investment manager is performance. It is important that the historical performance should be evaluated within the context of the process and philosophy of the firm. Past performance is an indicator of the soundness of the people, philosophy, and process of the firm, but it is not a forecaster of future performance.

It is important that managers have a consistent performance record that demonstrates value added over a sufficiently long time frame, with respect to return, risk and risk-adjusted return versus an appropriate benchmark and universe of managers. Consistency — good performance in both up and down markets, with no large deviations from the benchmark — is much more important than performance that has the occasional exceptional years. High but inconsistent performance is more often due to luck, or to taking an unacceptable level of risk, than to repeatable skill.

When considering a manager’s performance history, it is important to analyze the yearly and quarterly returns and consider numerous periods spanning various investment conditions to see if the manager is consistently above average or if periods of out performance are followed by periods of under performance. The performance of a manager in various economic environments will often depend on their investment style.

Although historical performance is an important consideration, it is by no means the most important factor and is not necessary an indicator of future performance.