Saturday, 18 February 2012

Evaluating Investment Results of Yourself and Your Fund Managers

The decision to employ an investment professional should only be made after a thorough analysis of the past investment performance of the individual or organization under consideration. Some questions are obvious:

  • How long a track record is there? 
  • Was it achieved over one or more market and economic cycles? 
  • Was it achieved by the same person who will manage your money, and does it represent the complete results of this manager's entire investment career or only the results achieved during some favorable period? (Everyone, of course, will be able to extract some period of good performance even from a lengthy record of mediocrity.) 
  • Did this manager invest conservatively in down markets, or did clients lose money? 
  • Were the results fairly steady overtime, or were they volatile? 
  • Was the record the result of one or two spectacular successes or of numerous moderate winners? 
  • If this manager's record turns mediocre after one or two spectacular successes are excluded, is there a sound reason to expect more home runs in the future? 
  • Is this manager still following the same strategy that was employed to achieve his or her past successes?

Obviously a manager who has achieved dismal long-term results is not someone to hire to manage your money. Nevertheless, you would not necessarily hire the best-performing manager for a recent period either. 

Returns must always be examined in the context of risk. 

  • Consider asking whether the manager was fully invested at all times or even more than 100 percent invested through the use of borrowed money. (Leverage is neither necessary nor appropriate for most investors.)
  • Contrariwise, if the manager achieved good results despite having held substantial amounts of cash and cash equivalents, this could indicate a low-risk approach. 
  • Were the investments in the underlying portfolio themselves particularly risky, such as the shares of highly leveraged companies
  • Conversely, did the manager reduce portfolio risk through diversification or hedging or by investing in senior securities?

When you get right down to it, it is simple to compare managers by their investment returns. It is far more difficult - impossible except in retrospect - to evaluate the risks that manger incurred to achieve their results.

Investment returns for a brief period are, of course, affected by luck.  

  • The laws of probability tell us that almost anyone can achieve phenomena l success over any given measurement period.  
  • It is the task of those evaluating a money manager to ascertain how much of their past success is due to luck and how much to skill. 

Many investors mistakenly choose their money managers the same way they pick horses at the race track. They see who has performed well lately and bet on them.

It is helpful to recognize that there are cycles of investment fashion, different investment approaches go into and out of favor, coincident with recent fluctuations in the results obtained by practitioners.

  • If a manager with a good long-term record has a poor recent one, he or she may be specializing in an area that is temporarily out of favor.  
  • If so, the returns achieved could regress to their long-term mean as the cycle turns over time, several poor years could certainly be followed by several strong ones.

Finally, one of the most important matters for an investor to consider is personal compatibility with a manager.  

  • If personal rapport with a financial professional is lacking, the relationship will not last.  
  • Similarly, if there is not a level of comfort with the particular investment approach, the choice of manager is a poor one.  
  • A conservative investor may not feel comfortable with a professional short-seller no matter how favorable the results, by contrast, an aggressive investor may not be compatible with a manager who buys securities and holds them.

Once a money manager has been hired, clients must monitor his or her behavior and results on an ongoing basis.  The issues that were addressed in hiring manger are the same ones to consider after you have hired one.

No comments: