3 Alternative Ways To Assess Your Investment Manager

By Gary Barohn AAA

While most investors would agree that performance is the overriding factor when assessing investment managers, often not getting equal attention are what we label the "other Ps". A close examination of these additional factors can provide a true forward-looking assessment of the advisor's competence and ability.

In this article, we'll take you through some of the most important Ps in management performance:

  • Philosophy
  • Process
  • People

Performance History
As evidence, performance tends to be the overriding focus of many investors. To see this, one need only observe the extremely large popularity of relative performance rankings by commercial services such as Lipper or Morningstar. (To learn more about mutual funds, see Advantages Of Mutual Funds, Disadvantages of Mutual Funds and Investing 101: A Tutorial For Beginner Investors.)

Unfortunately, professional investors know that raw performance history may have little or no bearing on a fund's or manager's future prospects. Empirical studies suggest minor statistical correlation between a large sample set of fund returns in one multi-year period compared with that same sample set in a subsequent, equal-length period. (To keep reading about mutual funds returns, see The Truth Behind Mutual Funds Returns.)

The Important "Ps"
One should look at the other Ps in addition to raw performance in analyzing an investment manager. Let's break down the three other Ps that you should be aware of:

1. Philosophy
A critical and close examination of the manager's overall investment philosophy should be paramount in assessing the investment firm. Investment styles go in and out of favor (i.e., growth versus value), but the consistency of the advisor's philosophy and focus should be a stringent requirement in assessing the advisor's integrity and soundness. Close scrutiny of the investment philosophy can often explain the rationale for specific security transactions implemented by the manager over time.

In many instances, mediocre managers over the long term have generated very impressive returns when their investment style is in vogue. When their style becomes out of favor, however, markedly different results are produced. (Find out more about popular investments in The Madness Of Crowds.)

A classic example of this is the late-1999 time frame when investors looked at the amazing returns generated by growth investors and failed to examine whether these returns were likely to continue in the future. The market collapse starting in early 2000 brought home reality fairly quickly to many of these investors.

2. Process
The investment process of an investment manager is the execution of their defined investment philosophy. The firm's research analysis and its collective view of its philosophy help define the process.

The information found in examining the process can help an investor gauge the risk associated with a particular manager's deviation from the team's process. An example here is a deep value manager who starts to purchase "hot" stocks in an attempt to improve near-term results, substantially deviating from its contrarian philosophy of investing.

You can gain some information about the investment process of a fund and its manager by reading the fund's prospectus, which can be found by contacting the fund or on its website.

3. People
The professional investment staff within the firm are ultimately responsible for seeing that the investment philosophy and process are executed according to plan. An investment management firm is not unlike any other organization in that success is a function of the individuals who make the decisions. Inevitably, the investment team is comprised of both strong and weak players, and it is incumbent upon senior management to make the appropriate changes necessary to fortify the former and minimize the latter.

Thus, monitoring hires and departures at the organization is critical. An investor who uses performance as his or her guidepost exclusively might hire a manager not realizing that the team that generated those impressive results have left the firm. (To find out more about researching your firm, see What To Know About Financial Analysts and Find The Right Financial Advisor.)

4. Other Considerations
Some other non-performance issues that investors need to be aware of and knowledgeable about when analyzing manager prospects include:

  • Does the manager's style and risk match the mandate of the account?
  • Has there been a change in the portfolio's fundamental characteristics?
  • Has there been a change in the firm's ownership?
  • Is the portfolio managers' and analysts' compensation structure consistent with their clients' objectives?
  • Is the manager able to fully explain his under-or over-performance?
  • Does the manager continue to instill a high confidence level in his or her written and verbal communication?

Bottom Line
Past performance can be an indicator of ability, and it is a useful tool in narrowing the universe of potential managers. That said, it is important to remember that performance is a function of the manager's philosophy, process and people. These non-performance factors are ultimately the key indicators of the manager's true future potential.

To learn more about portfolio leadership, see Should You Follow Your Fund Manager?, Will A New Fund Manager Cost You? and Why Fund Managers Risk Too Much.

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