by Pathfinder Asset Management
Fund management can seem daunting – yet investors and financial advisers must drill down into a manager’s investment philosophy and process. You need to be armed with the right questions, which means having a framework for understanding manager activities and structure.
In last month’s commentary we looked at fund manager “infrastructure” and broke it into four parts – People, Process, Price and Published Information. This month we look at the “investment” side and again break it into four parts – Philosophy, Product, Portfolio and Performance. This gives us a framework for asking the right questions.
Philosophy
Before you invest in a fund you need to understand the manager’s overall investment philosophy. Historically this discussion has been simplified to “active or passive” – but this binary approach is no longer appropriate. Investors should recognise that plenty of investment philosophies sit between purely index (passive) at one extreme and high conviction stock picking (active) at the other.
By way of example – how do you classify a fund using a rules based process to pick 100 stocks from the S&P500 that have the best valuation, momentum or dividend metrics? It’s not a traditional active fund, but equally not a purely passive fund. What if the manager then overlays active currency hedging back to NZ$ and active downside protection strategies – is that something different again? This fund is indeed active, but not in a conventional stock picking way.
Manager philosophy discussions need to be broader than simply considering the active/passive continuum. Philosophy covers many things – and be sure to ask how this impacts on the investor experience. For example:
- Time horizon philosophy: investing for longer time horizons can give more certainty than shorter horizons. Impact - the manager does not look to trade positions over days, weeks or months, but looks at horizons of over a year.
- Investor preferences philosophy: the pain investors feel from a $100 loss is much greater than the satisfaction investors feel from a $100 gain. Impact - this asymmetric investor experience means the manager focuses on downside protection.
After understanding the manager’s investment philosophy you can then focus on the fund objective. The fund objective is an expression of what the fund is intended to achieve – this should be more than just a return target.
Questions to ask on philosophy:
Product
After grappling with the investment philosophy and fund objective you need to understand risks taken, influences on returns and your ability to get money out quickly. This part of the review is very detail focused.
Questions to ask on Product:
Explain each of the following for the fund:
Portfolio
We now turn to how the fund is actually invested. As well as holdings this covers the decision process and research capability. Getting the manager to talk through actual buy and sell decisions is a good way to understand the thought process. Everyone prefers to discuss successful decisions, but whether you are a lawyer, landscape gardener, engineer or fund manager, the most valuable lessons come through mistakes. Don’t be afraid to ask about investment decisions (buys and sells) that went wrong - what did the manager learn? Were processes changed as a result? Why did the decision fail – timing? valuation? or just bad luck?
Managers should not just build a portfolio, they should constantly test it. How would the portfolio react to an unexpected event? You want to know both upside and downside sensitivity. What if a crisis occurred tomorrow like the Lehman Brothers collapse (2008), the US debt ceiling crisis (2011) or Japanese earthquake (2011)? What if the oil price jumped 30%, the Euro rose 10% or emerging markets equities fell 10%? Sophisticated portfolio tools allow managers to simulate these events or any mix of them. This is called “stress testing” or “scenario analysis”. Don’t be afraid to ask managers to talk you through their testing.
To understand what’s in a fund, don’t just rely on its name. The description “balanced fund” means different things to different managers. In AON’s June survey of the balanced fund category, the asset allocation across seven different managers varied widely:
| Asset class | Lowest allocation | Highest allocation |
| Cash | 0% | 14% |
| NZ fixed interest | 3% | 20% |
| Global fixed interest | 0% | 25% |
| NZ shares | 10% | 39% |
| Global shares | 25% | 43% |
| Property | 0% | 14% |
| Alternatives | 0% | 20% |
Similarly funds in the Trans-Tasman equity category have very different portfolios. In five different Trans-Tasman funds the number of stocks held ranged from 31 to 70 with the funds’ Australian allocations ranging from 12% to 52%. These are big variations – you need to drill down carefully into portfolios.
Questions to ask about Portfolios:
Performance
It’s no accident that past performance is last in this discussion. It is the most heavily relied on by investors and yet past performance can easily mislead.
Firstly find out what the performance benchmark is. If the fund invests in NZ equity stocks, does it compare performance to the NZX50 or the OCR cash rate? Is the choice of benchmark fair and sensible?
The importance of past performance is to compare to market performance. Has the fund done better or worse on a relative basis? Why? Did it take more risks through a few concentrated holdings or leverage? What impact did fees have? Do not base your investment decision on the assumption that returns (in absolute terms) over the past 1-3 years will be continued into the future. It is more returns relative to the market that you care about.
When you discuss performance ask the manager to provide you a breakdown of what they see as the greatest contributors (or detractors) of returns compared to the market. Was it an overweight holding in small caps or healthcare stocks that generated returns? Or an unhedged Yen currency position? Or an overweight to Germany? This is called “performance attribution” – the manager will be conducting this internally – ask them to share the results.
Questions to ask about performance
Summary
In this two-part commentary we have created a framework for thinking about funds and fund manager businesses. The first part of the framework is “Infrastructure”(covered in last month’s commentary): People, Process, Price and Published information. Secondly is the “Investment” side (covered this month): Philosophy, Product, Portfolio and Performance.
At Pathfinder we have summarised the questions you could ask managers down to a handy “cheat sheet” card. If you would like hard or soft copies of this please email john@path.co.nz. If fund managers are managing your (or your client’s) money you are entitled to ask questions about who manages it and how. You should plan the right questions in advance – and make sure the manager provides answers in a language you can understand.
Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz
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