Evaluating Discretionary Stockbrokers and Money Managers

Some stockbrokers function as money managers, having discretionary investment authority over some or all of their clients' funds. Practices such as these may entail serious conflicts of interest since compensation is made on the basis of trading commissions rather than investment results. Nevertheless, you would select a discretionary stockbroker just as you would choose a money manager. The questions to be asked are virtually identical. In both cases, while there are large pools of people from whom to choose, selecting someone to handle your money with prudence and fiduciary responsibility is never easy. 

The ultimate challenge in selecting a stockbroker or money manager is

• understanding precisely what they do, 
• evaluating the validity of their investment approaches (do they make sense?) and 
• their integrity (do they do what is promised, and is it in your best interest?). 

How do you begin to evaluate stockbrokers and money managers? 

There are several important areas of inquiry, and one or more personal interviews are absolutely essential.

There is no better place to begin one's investigation than with personal ethics.

• Do they "eat home cooking"- managing their own money in parallel with their clients'? 
• I can think of no more important test of the integrity of a manager and the likelihood of investment success than his or her own confidence in the approach pursued on behalf of clients. 
• It is interesting to note that few, if any, junk-bond managers invested their own money in junk bonds. In other words, they ate out. 

Another area of inquiry concerns the fair treatment of clients.

• Are all clients treated equally? If not, why not, and in what ways? 
• Are transactions performed for all clients contemporaneously? If not, what method is used to ensure fairness? 

A third area of interest concerns the likelihood of achieving good investment results.

• Specifically, does the broker or money manager oversee a reasonably sized portfolio, or have the assets under management grown exceedingly large? 
• One way to judge is to examine the manager's track record since the assets under his or her control reached approximately the current level. Investors can also examine the records of other managers to determine in general how increased size affects performance. 
• From experience, large increases in assets under management adversely affect returns. The precise amount that can be managed successfully depends on the specific investment strategy employed as well as the skills of the manager under consideration. 

A fourth area of inquiry concerns the investment philosophy of the manager.

• Does the broker or money manager have an intelligent strategy that is likely to result in long-term investment success? (Obviously, a value-investment strategy would be optimal.) 
• Does he or she worry about absolute returns, about what can go wrong, or is he or she caught up in the relative-performance game? 
• Are arbitrary constraints and silly rules, such as remaining fully invested at all times, absent?