By Neil Cockerill, Senior Investment Manager at Henderson Rowe
Humans are bad investors. Humanity’s instincts were honed in an era of cuneiform and clay, not computers and cardboard. Modern investment prowess is simply at odds with human nature.
So, how can an asset owner protect themselves from…themselves? Here is our step-by-step guide to selecting a quality investment manager.
Step 1: Accept That You Are a Bad Investor
This is critical and the most difficult step. Most asset owners have money to invest only because they’ve been successful elsewhere, which leads them to, wrongly, believe these traits will make them successful investors.
Research shows there is no correlation between investment results and wealth, social status, or education. Believing otherwise often results in ego-driven, concentrated bets that sink entire portfolios. In fact, overconfident private clients – and their managers – are by far the biggest losers in equities markets.
Step 2: Accept That Your Investment Manager Isn’t Much Better
In the UK private client market, most investment managers are “experts” only in a relative sense. Few can credibly claim direct and detailed knowledge of the strategies into which they are putting their client’s money.
Despite this, investment manager egos cause them to overestimate their own competence.
Most retail firms’ expense models indicate that a significant portion of it allocated to sales and marketing, including outsized commissions and perks. Accordingly, these firms focus on attracting people who are best at sales and marketing – not investment or research.
Selling to and servicing asset owners is an extremely valuable skill. But risk arises when managers don’t understand or can’t admit the limits of their own knowledge. The danger materialises when they come to believe their own hype, leading them to stake out poorly informed, ego-driven positions using client money.
Step 3: Understand the Value of Service
The most valuable thing an investment manager can do is protect you from yourself. It is a fact that despite all the problems in our industry, investors still earn demonstrably better returns with specialist financial advice.
Of course, it is not the only value investment managers can add. Investment managers conduct research and guide clients towards new and cheaper market exposures. For example, any investment manager who is not talking to their clients about ETFs is doing them a disservice. Good managers will regularly monitor asset allocations, advise on rebalances, implement restrictions, and assess portfolio risks. They will review suitability, ensure appropriate liquidity for life events, and coordinate with other advisors to promote efficiency and continuity.
Step 4: Understand the Value of Product
In this context, “product” means the methodology and underlying research used to guide investment decisions, as opposed to “service” which is how that methodology is implemented and communicated to the client.
Most London firms invest far more in sales and marketing (“service”) than in proprietary investment research (“product”). As such, many of these firms are not really “investment managers” at all – they are just sales and distribution platforms buying third party products for their clients.
When selecting an investment manager, make sure your chosen firm prioritises research over sales. An easy way to determine this is by assessing whether the firm publish pioneering research, have speaking engagements at academic or research conferences.
Step 5: Assess Transparency
The transparency issue is three-fold.
We’ll start with fee transparency. Unfortunately, retail managers have succeeded in making fees extremely confusing. True costs are obscured by additional fees, such as entry and exit fees, lock ups, special charges and complex or structured solutions, obfuscating poor performance with cherry-picked benchmarks and misleading back testing.
Regrettably, to date, this has been an incredibly profitable model for retail managers. However, investors should steer clear of firms with complex fee structures, including ones that generate revenue in ways that are not immediately obvious. There may always be reasons for perturbations in fees, but they should be easy to understand and measure.
Investment research transparency is another that investors should probe. Ask your manager questions like:
- Where is the research coming from?
- Are they paying for it or conducting it in-house?
- Is the research differentiated?
- Can you understand the research and how decisions are made?
- Who are the specific people involved?
- What are their qualifications?
- How is the research integrated into portfolios?
- Who are the actual people making underlying investment decisions?
- How much is invested in research versus sales and marketing?
- Can you talk directly to the people who are making fundamental decisions regarding how your money is managed?
Those managers that do not conduct their own research and essentially act as sales platforms charging you a management fee will struggle to answer these questions.
Finally, you should explore the transparency of your manager’s products. Numerous differences exist between retail and institutional products. Without a doubt, all investors should look for managers who are proposing products of an “institutional-quality”. Such solutions:
- are evidence-based;
- have an industry-recognized and, typically, published, behavioural or theoretical basis;
- focus on efficient implementation (e.g., lower portfolio turnover), and not just investment methodology;
- have reasonable and published performance benchmarks;
- place little importance on backtests or recent short-term performance;
- have low fees or performance-based fees;
- apply over long investment time-horizons of between 10 and 100 years.
Selecting a quality manager requires due diligence. However, if handled properly, it’s a decision that you’ll only need to make once in a lifetime. If it still sounds too daunting, you may be better off without a manager at all. Just put your money in a low-cost ETF and walk away. That is not a bad solution if you have the self-discipline to withstand volatility.