After evaluating a mutual fund’s relative performance, a review of fund management should be completed.
Why?
One, it is important to know who is choosing the investments within the fund.
Two, the fees paid to management are a significant percentage of total operating expenses.
If you are paying a lot of money for active management, you had better get good value.
In assessing fund management, here are a few things to check out.
Manager Performance
Obviously how a fund performs is key to in assessing management.
As it is fund management that makes the investment decisions, you can use the guidelines from Mutual Funds: Performance and Mutual Funds: Performance is Relative to help assess fund management’s performance.
In gauging manager effectiveness it is crucial to compare a fund’s managers to their peers and appropriate benchmarks.
How do other managers perform on the same playing field? That is: choosing from among the same possible investment universe; following the same investment style; operating in the same economic and market conditions.
Equally important is to assess management performance against no active management decision-making (i.e., passive investing). Does the money shareholders pay in management fees generate a positive return versus simply investing in a non-managed index fund? In investment jargon, does the active manager produce “alpha”?
This is the important active versus passive management debate that we will discuss in an upcoming post.
Manager Tenure
Maybe you are considering investing in Alpha US Large-Cap Equity Fund (Alpha).
From your research, its 5 and 10 year performance is extremely high relative to its peers and benchmarks. You are a little concerned about relative underperformance over the 1 and 3 year return periods, but you believe the long-term results make it a worthy fund for your money.
Perhaps.
But what if you learn the key fund managers left Alpha 4 years ago and were replaced by a new management team?
That may explain why the fund’s relative performance slipped in recent years. Maybe the investment tactics employed by the new managers are inferior to the previous ones.
Based on Morningstar data, the average fund manager stays approximately 4.5 years at his fund. That means there is a strong probability that fund management will change while you own a specific mutual fund.
It also means that you will be analyzing funds’s long-term performance that is not the result of investment decisions made by the current managers.
When assessing a fund, find out how long the current management team has been in place. If they have only been running the fund for a few years, they should not get credit for the performance of the previous team. Conversely, they should also not be blamed for poor results from now departed managers.
New Fund Managers
New fund management may be a positive or a negative.
If new managers were brought in to replace under-performers, then fund results may improve. That is good for investors.
If new managers are replacing successful ones who have left for greener pastures, then it might not be a good thing.
For new fund managers that may not have long-term results in their current fund, you need to look at their previous positions to assess the likelihood of success in their new roles.
In our example, Alpha is an equity fund investing in US large-cap stocks.
First, I would expect to see that the fund managers have experience in this investment category. If their previous management was in bond or money market funds, I would question their future success in an equity fund.
If they do have experience with equity funds, how close is it to the investment style of the fund you are considering? Analyzing US large-cap stocks is somewhat different than researching European small-cap companies.
Ideally the fit between their past experience and current jobs should be close.
Second, a new manager should have demonstrated success in his previous funds.
If a fund manager has no positive middle to long-term track record, I would be leery of letting him manage my money.
Old Fund Managers
Consider why a fund manager leaves a fund.
Did she move to a larger fund with more career potential? That may indicate that there are no problems with the fund. Simply that it was a good career move for the manager.
Or perhaps there was a problem with the current fund and it was like the proverbial rats leaving a sinking ship.
Why someone leaves is a factor and can indicate potential future performance issues.
For example, maybe the fund is experiencing significant shareholder redemptions. This would require the fund to liquidate some of its investments to have cash to pay out investors. This may impair a manager’s investment strategy and create future performance issues. With limitations on investing strategy (due to the need to maintain cash reserves for redemptions), a fund manager may feel constrained and leave for another fund with more freedom.
Another consideration with departing managers is their star power. In the past, funds promoted their star managers and used them to attract investors. If a celebrity manager leaves, will that cause an increase in shareholder redemptions?
Bear Market Managers
During bull markets (when the asset class is going through a general increase in value), it may be difficult not to make money. Even mediocre managers can attain strong performance.
The test of a manager’s skill is when the market is stagnate, or during bear markets (when the asset class, as a whole, is decreasing in value).
If you can determine how your manager performs during periods of both good and bad economic times, you may get a better feel for his expertise.
A common problem is that many fund managers are relatively young. As such, they may not have experienced multiple bull, bear, or flat markets. So it may be difficult to assess this in a fund manager.
Index Huggers
If you buy an actively managed fund, you pay a significant amount each year for fund management. Make sure that it is actively managed.
Index huggers (a.k.a. closet or pseudo trackers) are active managers that essentially just try to re-create the index used as their benchmark.
Fine if you are buying an index fund with a tiny management fee. Not fine if you are paying for active management, yet actually getting an index fund.
This can be a real problem for investors.
The WM Company, a Scottish based market research firm, analyzed fund data between 1980 and 2000. The study found that 74% of actively managed funds deviated less than 6% in their holdings from their benchmark index. That means that if an equity benchmark had 100 stocks in it, 74% of the mutual funds reviewed would have at least 94 of the same companies. And of that 74%, a full 40% of the funds had deviations less than or equal to 3%.
Why pay a management fee to someone who barely differs from the benchmark holdings?
To monitor for index hugging, you can review a fund’s holdings versus the benchmark investments. If they are highly alike, there may be an issue.
You can also consider what added value, if any, the actively managed fund provides over an index fund (i.e., a passive fund that merely tracks the benchmark index). If you do not see extra value, do not pay for the active management.
Management Teams
It should be noted that many mutual funds have moved to a management team concept rather than promoting single or co-managers. There are a few reasons for this shift.
One, while celebrity managers can attract new investors, they can also hold funds hostage in compensation demands. The star managers know that if they leave a fund, many shareholders will come with them. This gives the star leverage over the fund. By emphasizing a team approach over one celebrity manager, the leverage diminishes.
Two, team management promotes a consistent investment approach. With an average tenure of 4.5 years per manager, there is frequent staff turnover. A team allows for better internal consistency which should lead to better predictability of future performance.
Three, as with internal consistency, a team approach allows one to attribute long-term results to current management. The current managers may not all have been in place for the prior 5 or 10 years, but the team philosophy and strategies should be comparable between all periods.
For these reasons, I tend to prefer a team approach over single or co-managers.
Fund Manager Ownership
Funds may disclose the amount of personal money their managers have invested in the fund.
Some people believe that the greater a manager’s own capital is invested in the fund, the more they will be focused on fund performance. If the manager has no personal interest in the fund, they may have less focus.
While I can understand the argument, I give this little weight in my analysis.
Fund managers are professionals and should manage the fund in the same manner whether or not they have a significant personal stake in the fund. Also, their remuneration and opportunities for career advancement are tied to their results. To me, that is far more important to their long-term wealth than whether they invest in the fund themselves.
