Investment manager styles and timingJuly 27, 2015
When looking at investment managers, we here at FolioDynamix are primarily looking for active managers that can add long-term value beyond their benchmarks. That’s the easy 30,000-foot description. As you get closer to the ground, details start to matter. What constitutes long-term? What counts as being active? What is the appropriate benchmark against which to measure performance? Many different factors are at play. The more obvious ones involve individual products. Is the manager any good? Is the historical track record relevant to assessing the current management team? Somewhat less obvious factors come into play when looking at the approved list as a whole.
It is too narrow to isolate the research decisions to one based on investment merit alone. Business concerns start to factor in. A prime example of which is to make sure there is enough diversity on the approved list for each asset class, no matter the point in the market cycle. A bias toward quality-focused managers, all of whom might be exemplary, as your only choices can be problematic for a research provider. As we have pointed in previous reports, having a “quality” bias, however one cares to define it, has been a drag on performance for most of the time since the market started its run in March 2009. For better or worse (and I tend to view it as worse) this industry operates under the tyranny of trailing three-year and five-year numbers. If a critical mass of approved products doesn’t look good under those conditions, then clients may start taking you to task for a “bad” list. So it definitely pays to have a diverse list of managers. Some bond managers focus on credit research while others make duration bets. The international managers should not all “cheat” vs. the MSCI EAFE by being 20%+ in emerging markets. Large cap value has some traditional value, some dividend value, and if they still exist, even some deep value managers. Hopefully something in each asset class is doing well at any given moment.
This brings us to the current state of affairs with regard to our approved list. In most asset classes we do have a diverse group of managers in terms of their style. The domestic small cap classes may be exceptions, but that is more a case of them closing than us not striving to have a diverse group. After seven years of what has for the most part been an uninterrupted rally, it is apparent that we do have a systemic bet across our list that is not obvious at first glance. Most of our managers tend to be more defensive than their benchmarks. In risk-adjusted terms they may be great, but in terms of raw trailing performance they are not keeping up, and in a trailing performance world that can be a bad thing. One may wonder why our approved list is skewed toward these “quality” managers which are more defensively oriented than their benchmarks; as noted in the whitepaper titled Quality Bias – An Unusual Headwind for Active Managers and Due Diligence Providers Alike published by our research team in early 2015, “high quality” strategies historically have outperformed “low quality” managers in four out of every five calendar years on average. When taking a long-term historical analysis perspective as our research process dictates, it thus stands to reason that the majority of strategies which meet performance thresholds are more likely to fall into the “high quality” bucket than the “low quality” bucket.
Part of the reason for this attribute is simple historical happenstance. As already mentioned, products tend to be approved when they look good over the last three-year and five-year performance periods. If one looks at the combination of UMA and SMA approvals since 2003, 75% of the approvals had a major bear market in the recent rear view mirror. It was either the tech bubble bursting of 2001-2002 or the financial crisis of 2008-2009. The managers that looked best at those times were ones that lost less than the benchmark, i.e., defensive managers. Now that we are seven years into a bull market, those periods of outperformance have fallen out of the five-year performance history. The managers that look good now are the ones that do better than the benchmark in the good times, i.e., more aggressive styles and/or higher beta approaches.
Now, having a list of approved managers that is mostly defensive is not necessarily a bad thing. If behavioral finance is to be believed, a dollar lost is three times more painful than a dollar gained is pleasurable. So when the inevitable future correction occurs, investors in our list of managers may be well positioned to weather the storm and hopefully will be pleased with their advisors. However, we do recognize that at the present time it would be good to have some more options with upside capture ratios greater than 1.00 on average. Advisors need to gather new business too, and underperforming managers, even if they are doing so for the right reasons, makes that difficult. Few people are able to bring themselves to invest in such strategies with new money, even if they might stick it out with already invested money.
So don’t be surprised to see some higher beta managers being approved by us. Penn Capital Management’s Small Cap Equity strategy is a recent example of such. One caveat to keep in mind though is we suspect approving such managers at the present time is somewhat perilous. The risks of a market correction seem pretty high in the view of our investment policy committee. Adding higher risk, more aggressive managers right now may not be the best idea. However, we are looking for managers that will add value over a full market cycle. Manager approvals are not based on market timing tenets. Rather approvals are based on the merits of the product and through the process we gain a full understanding of the market environments that work best for the strategy allowing you to make an informed decision understanding the risks. In any case, if the market does correct, then a good number of our high quality managers that do not look so good now should look much better.
Contributed by: David Chandler, CFA, Director of Research