Sunday, July 31, 2011

Fund Choices: Questions are Better than Rules


This post is being composed during the long weekend of deliberation on spending and taxes in the US. These endless, and in many ways pointless discussions and the resulting actions taken, will have some short-term impacts and will set up further imponderables for the future. All of this is of interest, but our clients pay us to provide long-term solutions to their needs. Thus, I need to focus on finding good investment choices of funds and separate account managers.

Citywire Global, an informative website and magazine for international fund selectors, asked its audience, “What are the rules you use in your selection process?” This approach is similar to those used by consultants and "gate-keepers" in the US. This “rules based approach” also works well in many manufacturing activities. Rules provide particular comfort to large organizations and those who like being within a crowd.

Wise investment decisions are an art form

While there is a great deal of math within investments, I believe that making wise investment decisions is an art form. I have held this view for many years after my failure to find absolute investment rules. This belief was reinforced this weekend when my wife Ruth and I attended the wonderful Aspen Music Festival. We heard Mahler's 4th Symphony and will hear his 5th on Sunday. This year is the 100th anniversary of Gustav Mahler's death. His track record includes ten symphonies, which many believe was essentially one continuous probing of the meaning of life and death. Many orchestras around the world, including the Sydney Symphony, the Berlin Philharmonic, the London Symphony Orchestra as well as the New Jersey Symphony and the New York Philharmonic noted the anniversary of his death by playing his music this year.

I believe the collective experience of these concerts has a direct bearing on the reliance of the past performance of great investment managers. For instance:

  • Many, if not most of the anniversary concerts played particular interpretations of Mahler’s music. Many investment strategies have the same notes from a previous genius (EPS & other facts), but will get different results.

  • Concert performance differences can be caused by the size of the orchestra. The results of a fund or portfolio is shaped by the size of the universe of available investments.

  • Affecting the overall music are the individual talents within the orchestra. The varying abilities of supporting securities analysts similarly contribute to invesment returns.

  • The availability of good soloists is critical to a performance. External research/intelligence sources are essential to successful investing.

  • The acoustics within the hall affect every performance. Location-dependent results, e.g., different currencies, market caps, the use of external brokerage, etc., greatly affect investment results.

  • The talent and personality of the conductor is constantly on view. The investment manager brings his/her own attitudes to help shape a portfolio.

After 100 years, experts still have different interpretations from the same inputs.

Critical elements missing

Critics and others in the media focus on the total results without adjusting or commenting on critical elements. For example, for many years the late and great Sir John Templeton was celebrated for his fund's great performance in the early 1960s. Few noted that most of the superior performance was due to large investments in Japan, not repeated in the rest of his long and distinguished investment career. Other high-profile fund leaders were celebrated, with little or no comment about the portions of their portfolios that seriously underperformed. A number of the portfolio managers (PMs) named, by others, as the “Manager of the Year” (or Decade), had the humbling situation of producing poor results right after being overwhelmed by receiving media accolades.

What are some of the questions for today?

The first series of questions for past good performers revolves around the changing structures of trading. With the locations of trading fragmented and no real central marketplace recording prices and total volumes, how do PMs know what is happening beneath the surface of the reported prices? Further, how have the practices of quantitative trading (algorithms), changed their ability to accomplish large trades in a turbulent market?

One of the things that happens to successful managers is that materially-increased cash flow moves into their funds, some from short-term investors. How are they dealing with this flow? Often as investment organizations grow, leading PMs are required to manage an increasing number of accounts. Further, they become responsible for more people and functions as they add executive responsibilities. How are these changes impacting the time available for investment decisions? Is the amount of money and available choices within their target asset classes changing substantially, and how will that impact their efforts? Has the nature and strength of the competition changed? Will this impact their organization?

An interesting question that came up at dinner Saturday night with a very well known and respected PM who has been “retired” for more than five years, is how much of his extraordinary results originated from working with selective industrialist clients on their private investments in non-public companies? The greater understanding of the economics and the personalities involved aided the PM in his selection of public companies. There are a number of other examples of these special insights. What happens to the performance of the PMs when they are no longer having these conversations?

We have come to expect something different every time we hear a great symphony play a popular piece of classical music, just as we now expect a somewhat different result from a great portfolio manager in an ever changing marketplace. Our analytical strength is in the questions we ask, not finding good past records.


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