Don’t just follow the crowd
This essay appeared in Citywire Selector on February 24, 2010.
Over the past couple of months, I have been re-evaluating many common tenets of the manager selection process. My goal has been to separate what is done out of convention, habit and convenience from what is actually meaningful when identifying great managers.
Sometimes things are considered to be industry best practice when, in fact, they have simply become common practice. If there has ever been a time to question assumptions and examine what is really useful in our industry, it is now.
While every selector, motivated by experience, applies their own unique twist, there are common themes among the different selection processes. And as selectors discuss their methodology in public forums and move between firms, commonalities in approach are increasing. Like the convergence we are seeing in investment techniques (through ‘Newcits’ funds, for instance), manager research methodologies are coming together across product varieties, geographies and investor types.
Nearly every selection process begins and ends with the numbers. Performance figures are the most commonly and readily assessed aspect of picking a manager. As selectors, we continuously discuss the metrics used to analyse performance data. Questions such as, ‘Is downside deviation more meaningful than standard deviation?’ or ‘Have we chosen the correct benchmark index or peer group to compare?’ are constantly discussed. These questions are important. However, such calculations rely on a major assumption – that the time periods on which the analysis is based are reasonable and appropriate.
Is there something inherently magical about the time periods we use? One, three, five, seven and ten years are used as standard by nearly every selector, consultant, reporting institution, database, rating agency and media outlet around the world.
By far the most common, however, is the three-year timeframe. It is difficult to estimate the amount of money moved in and out of investment products in any given year based on three-year criteria – but globally, the number must run to trillions of euros. Three years is the key figure in determining whether or not a fund or manager is even eligible for selection. Along with an asset volume level (typically 100 million euro), a three-year track record is the threshold criteria. Funds with a shorter track record are simply passed over.
For selectors who use a structured quantitative screening process, the amount and quality of data is crucial. One important consideration is the number of data points needed to ensure what is termed ‘statistical relevancy’. Given that most selectors in Europe use at least weekly data and in many cases daily data for running analytics, it is hard to make the case that three years is still necessary.
Using daily data, a more robust set of analytics is possible over a shorter timeframe. Perhaps the need for three years is a legacy from when only monthly (36 data points) or quarterly (12 data points) performance information was available.
Assuming that a fund with a three-year track record is inherently less risky than a fund with a shorter track record can be dangerous. In some cases, the length of track record can give a false sense of security – three years does not provide a sufficient window to evaluate a manager during a full market cycle.
Three years, it seems, gives some people the idea that track record provides a stable foundation on which future performance can be generated – this is just not the case. In fact, studying the cyclicality of many manager returns suggests the opposite is true for relative-return and style-pure managers – particularly in volatile markets.
The best-case scenario for asset managers, selectors and investors alike is when a new fund is launched because a true investment opportunity is seen in the market or a talented manager has identified an inefficiency to be exploited. Assuming the manager is acting prudently, this is precisely the moment when one should consider investing – not three years down the line. The decision should be easier when the firm and manager are already well known in the sector.
While you wait for that three-year track record to develop, alpha opportunities are potentially slipping by. If a fund is launched because of a real market opportunity (as opposed to just filling a hole in a manager’s line-up) it makes sense to initiate the investment early while the inefficiency spread is wide and/or the manager is still small enough to be nimble.
Selectors have a real opportunity to gain a significant competitive advantage by adopting a more flexible threshold. Why not use 2.5 or 2.75 years as your threshold? That way, once the questionnaires have been returned and meetings held, you will have a head start on the competition.
Or why not start the process at two years? Or, if the potential of the fund is great, why not six months? The timeframe is ultimately less important than using a process that is not only well designed, but built on independent thinking – not just blindly following the crowd.