assessing fund manager performance beyond the numbers

Most retail investors assess performance of their mutual funds by looking at one number – returns. What most investors ignore is the risk that your fund manager took to get you that return. That is to say “how many sleepless nights did your fund manager give you for getting those returns”. Thus bigger fund performance analyzers would look at “risk adjusted returns” instead of just looking at raw returns. When I mean a fund manager I mean a fund house not the individual who is named as the manager for the scheme that you are evaluating. However, what is often overlooked are the forces actually driving performance. Some more soft indicators that you should see are –Is the achievement caused by a team performance or by a sole person? Fantastic in theory impossible in real life.Has the achievement been marred by actually sitting on cash when the market came down? The fund manager in a mutual fund has a buy only mandate. He cannot decide on how much cash to sit on. Such behaviour is dangerous even though it may have yielded results in the past. Is he true to his label?  Has the fund manager happily given up his mandate of being a large cap fund and bought mid caps to achieve performance?  If yes, that is also worrying.

Let us look at all of them in some detail.

Performance History
Investors tend to overemphasize investment performance history when selecting an advisor. The widespread reliance on performance in mutual fund selection can be seen by the immense popularity of relative performance rankings. Television shows fall over each other to announce “fund of the week” “fund of the month” etc. If suddenly we find programs calculating the NAV of a fund at 2 pm and rank intraday funds, do not be surprised.   Unfortunately, professional investors know that raw performance history may have little or no bearing on a fund’s or manager’s future prospects. A lot of research in the US has shown that money comes into a fund soon after a great performance and leaves after a poor performance. In fact there is convincing evidence that you should be leaving the best performer and picking up a weak fund! 
Although performance history is certainly useful in analyzing an investment manager, it should not be used in isolation. To borrow a Peter Lynch phrase this is equivalent of driving by looking only in the rear view mirror.   

Let us look at some other things that I am comfortable looking at:

Outlook and Philosophy :

A clearly defined philosophy leads to a consistent investment strategy that can indicate the type of performance to expect in different market environments. Understanding a manager’s process allows investors to objectively examine investment decisions that are made and gives some possible clarity as to why they were made. Active managers have some distinctive styles – growth, value, opportunity, sectoral bias, etc.  Managers may find environments where it is easier or harder to deliver acceptable returns. For example for a market like the Indian market of today a dividend yield fund manager could struggle.It is very difficult to find out whether a fund manager is generating a good return because of his skill or because of an environment that allows him to succeed in that style. An even more difficult challenge is trying to predict what style will be in favor at any point in the future. You are not paying homage to a great performance you need to ride it, don’t you?  In the past 4-5 years any advice regarding asset allocation, gradual entry (STP) etc would have looked funny because of a secular bull run. However whether next 4-5 years will be the same cannot be answered.A classic example of this is the herd mentality of chasing any thing with a dot and a com in the late 90s. Value investors, dividend yield investors, and the likes were made to look like buffoons. However today you cannot find a DSQ, Silverline, Pentamedia, etc. anywhere in the stratosphere. Currently my money is with a great fund manager who has a 3 year track record in public – it helps that I know his 15 year track record. I do not know the NAV, and can rest in peace simply because I believe in the Value philosophy and his competence.    

Operations and Processes

Each manager will use an investment process that is the sum of the team’s research, analysis, insight and collective view of its investment philosophy. If you are sure that there is a process and it is adhered to you need not look at daily NAVs. Being trained as a CA sets one thinking so much in terms of audit, compliance, and procedure that deviations hurt. If a fund manager in whom people have reposed faith changes from being a large-cap fund to a “hot-tip” fund manager it causes panic in me. I cannot take the extra bile that is generated.       
Organization and People

The investment team is ultimately responsible for developing and executing the philosophy and process. An investment management firm is not unlike any other organization in that success is a function of the individuals who make the decisions. Each management team member will have areas of strength, and these will be reflected in the philosophy and process. This highlights the importance of personnel changes.An investor looking only at performance may be buying into a fund or managed account strategy where the team that is responsible for the fund’s track record is no longer in place.

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?
  • 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?
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-mathematical performance factors are ultimately the key indicators of the manager’s true future potential.

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