Picking a money manager

It has been well documented (by organizations like Dalbar as well as tons of academic research) that investors get lousy results over time. 

One reason is that they try to do the investing themselves, but lack the knowledge, skill or temperament to invest successfully. Another reason is that they’re lousy at picking money managers. I can’t help with the first problem–it’s up to each person to be honest with themselves about their own abilities and results–but I can help with the second: picking money managers.

There are basically two ways to pick a money manager:

  1. Examine past results
  2. Examine a manager’s process to see if it is a good one

The benefit of examining past results is that it can be done quickly and seems objective. The problem is that separating random luck from real skill is extremely difficult. 

Every money manager’s past record includes a component of randomness, or luck, and a component of skill. How do investors know whether they are seeing a record due to luck, or skill? They don’t.

Investing results are much more random than most investor recognize, especially over the short term. Looking at a record of less than 3 years is likely meaningless. Records of more than 3 years are more meaningful, but even outstanding money managers can under-perform for 5, and sometimes even 10 years!  Correlatively, some managers have great records that don’t last because they were lucky, not skillful. 

Most investors examine past records, but their ability to pick good managers by looking at investing results is terrible. Even professional consultants and investment committees filled with experts get this wrong much more often than right.

Examining past records has a dreadful track record of successfully picking managers.

The other option, examining a manager’s investment process, is much more time consuming, but has a much better chance of being done successfully.

Specifically, there are two measures that seem to be both reliable (persistent) and valid (actually lead to the desired result).

The first is called active share, which is a measure of how different a money manager’s portfolio looks from the general market. To beat the market, you have to be invested differently than the market. You want to find a manager whose portfolio looks different than the market, and therefore has high active share.

The second measure is called tracking error, which is a measure of how differently a manager’s portfolio moves relative to the market. If a manager is all in cash, his portfolio will not move up and down with the market at all, and that leads to high tracking error. A manager who owns the same stocks in the same proportions as the market will move in lock-step with the market, and that leads to low tracking error. 

A manager with a good process tends to have moderate tracking error, which means his portfolio neither moves precisely with nor against the market. Such a manager doesn’t try to time market segments (all technology or all energy), nor does he try to pick “winning” asset classes (all cash or bonds to get in and out at the right times). A good manager picks investments that don’t mirror the market, but that do tend to move in the same general direction as the market over time.

Most investors use the wrong methodology to pick money managers and their results suffer. Instead of looking solely at past records and hoping they can guess whether that record reflects luck or skill, investors should look at a manager’s process. 

If a manager picks investments different than the market (especially if those investments have been carefully analyzed), and doesn’t try to time segments or asset class exposures, you’re likely to have found a manager that will get good results in the future.

Examine a manager’s process, not just their record.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Picking a money manager

What’s in a name?

Quick quiz. Would you prefer to work with a: 1) financial planner, 2) investment planner, 3) money manager, or 4) wealth manager?

If you feel like I just asked if you like: 1) pizza, 2) pizza, 3) pizza or 4) pizza, you are not alone. The financial intermediaries who claim to be these things can’t keep it straight, so no one should expect clients to, either.

In a recent study by Cerulli Associates, Inc., 1,500 financial intermediaries were found to mis-identify themselves as something they weren’t, frequently exaggerating the services they offer.

According to the study, 59% of financial intermediaries identified themselves as financial planners–certified to work with clients in building comprehensive plans that include insurance and estate planning. Cerulli’s study, however, found that only 30% of those 59% actually fit that description.

22% of financial intermediaries called themselves investment planners, who focus on asset management, retirement and college savings plans. 56% of the survey’s respondents actually fit that description, which makes it sound like a lot of investment planners try to pull themselves off as financial planners.

11% described themselves as wealth managers, who do comprehensive planning for wealthier clients, but only 6% actually fit the description. Once again, it sounds like an inflated title is used in hopes of generating business.

It turns out that money managers, who manage and build investment portfolios (that’s what I am), were the only group that accurately described what they do. Apparently, they knew what they were and weren’t afraid to describe themselves as such.

I must admit, I’ve run into this confusion a lot with clients, prospective clients, and even friends and family. Someone asks what I do, and I describe that I manage money for people.  Then, they say, “So, you’re a financial planner,” or “So, you’re a stock broker.” I don’t blame them for the confusion, but I do blame my industry.

There are a lot of honest people in the financial services business, but it doesn’t seem like a large majority. Specifically, a culture exists that focuses on commission-based sales, and convincing people to purchase “products.” An old industry adage is that insurance products aren’t bought, they’re sold. Looking at how most financial intermediaries are compensated, you’ll see that the adage is all too true.

I’m highlighting this not just to pat myself and other money managers on the back (whoopee, I’m on Team Honest!), but to illustrate how the financial services industry seems to thrive while confusing clients.  

A helpful term to look for is fiduciary.  A fiduciary “must act for the benefit of their clients and place their clients’ interests before their own” (CFA Standards of Practice Handbook).  

When you go to a Ford dealership, you don’t expect a commission-based salesperson to recommend a Toyota, but when you are talking to a doctor, lawyer or another professional, you should expect them to treat you fairly.

When dealing with a professional, you are placing yourself in a position of trust with someone who is an expert in a field where you aren’t.  It would be unfair, and frequently illegal, if the professional used that position of trust to benefit themselves at your expense.  That is why so many legitimate professional organizations require members to adhere to a code of ethics (and will boot you if you don’t!).

When a so-called financial planner earns a 5% commission (yes, on the gross amount of the dollars you invest) because you invest in the mutual fund they recommend, that’s not adhering to a fiduciary standard.  When an insurance agent earns a 10% commission selling you a whole life insurance policy or variable annuity, it should be clear their supposed advice is tainted by a big conflict of interest.

The best way to protect yourself, whether you’re dealing with someone who claims to be fiduciary or not, is to ask how they are compensated.  That should make it clear whether they are serving themselves first, or you.

What’s in a name?  It turns out, a lot.  

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What’s in a name?