One of the most common investment pitfalls is to back the current winner. All too often investors pile into the best performing share, asset class or fund manager over the past year in the hope that its success will be repeated. This type of naïve momentum strategy can pay off in the short term, but investors quickly find that prior successes are not so easily replicated.
Very rarely does this kind of momentum strategy hold up in the world of managed funds, even over relatively short periods of time. For example, looking at three-year rolling returns for global growth managers, it’s clear that performance can get shuffled around a lot. Those who have outperformed over the previous three years can easily find themselves near the bottom of the pack over the next three years. Equally, those languishing near the bottom can suddenly find themselves out in front of the pack.
Following the winner can make you a loser: Global growth manager return rankings (2016 versus 2019)
Obviously, if your manager research is focused on performance, you need to take a long-term view. The challenge, however, is that your analysis will inevitably be limited to those managers who have built up a sufficient track record. There’s also the classic survivorship bias problem: researchers tend to focus on the performance of those funds that have managed to remain in existence over their period of analysis. For active managers, medium- and long-term market dynamics can also have a significant impact on performance. For example, there will be periods when the market favours growth managers and periods when it favours value managers. Just because growth has outperformed value over the past decade doesn’t mean it will continue to outperform in the next. A change in market fundamentals can upend even the most thoroughly researched investment theses.
This all creates a significant conundrum for quantitative research. While qualitative research methods are sometimes criticised for being subject to arbitrary rules, in fact it’s the opposite that proves the case. Determining which quantitative metrics are relevant for which managers over which timeframe is difficult to do with a high degree of precision or confidence. Determining which are the main predictors of future performance is nigh impossible.
So how do successful researchers overcome this challenge? Clearly, quantitative measures are essential in assessing which funds are capable of delivering on their investment objectives. But they are far from the only measures that should inform your investment decisions. Qualitative factors should ideally make up the bulk of your research, but they tend to play a back-seat role because gathering the qualitative intelligence required to pick successful managers is a resource-heavy, time-consuming task. This can result in its own form of selective bias, where researchers focus on those factors that are relatively easier to measure and compare.
The limitations of quant-only research
Selecting the right manager involves looking at more than just past performance. It’s about delivering future outperformance based on an in-depth assessment of individual investment teams. This means understanding how people, strategies, and capabilities come together to position fund managers for success. When it comes to selecting for future success, qualitative research is not merely a filter or a heuristic, it’s the backbone of your entire research process.
While you might be able to get away with poor manager selection when the bull market is raging, the real test comes when the market reaches a turning point. Given the troubling signals from financial markets over the past six months, this is something many investors are starting to take very seriously. Market turning points pose a real challenge for fund managers and have a way of pushing their process and discipline to their absolute limit. In times like these, product recommendations and manager selection really count, and advisers can quickly find their own processes exposed when things go wrong.
Identifying future outperformance is an artform, not a science. Lonsec’s entire research process is built around understanding the range of qualitative factors that determine manager success and giving advisers the tools to select investment products based on individual client needs. Our analysis is based on an onsite assessment of investment teams, combined with a rigorous peer review process that safeguards the quality and integrity of our investment product ratings. Looking back over the past 10 years, our qualitative process has proven its worth. Lonsec’s Recommended and Highly Recommended managers have outperformed their respective benchmarks, even during a period where the long-running beta rally has pushed passive investment strategies ever higher, casting shade on many active managers who have struggled to offer value in this environment.
Performance of Australian equity managers rated Recommended or higher by Lonsec
Performance of global equity managers rated Recommended or higher by Lonsec
Source: iRate. Average performance is calculated based on historical monthly performance of managers currently rated.
Despite the fact that some active managers struggle to beat the market, we know that there are some that can consistently outperform. But identifying them has little to do with their past performance and much to do with having the right people, resources and processes in place to deliver on their mandate. Looking back through history, there have been funds that have been highly successful, producing people who went on to found their own funds and enjoy similar success. For new funds and products entering the market, there’s often no track record to speak of, meaning qualitative factors are the only means to measure the likelihood of success. If you screen these products out simply because you don’t have enough performance data, you risk missing out on new innovations and strategies that could prove highly valuable.
People and resources
Arguably the most important factor to consider when assessing a fund is the people responsible for making the investment decisions. Your research should take into account the size of the team, its quality, its stability, and its key person risk. Is the team large enough to carry out its mission? Does its analysts have the right level of experience and a track record of success working together? Is the fund overly reliant on a single person whose departure could adversely affect the fund’s performance?
Your research should also examine the culture and structure of the fund. Does the investment team demonstrate a real passion for investing? Do they treat it as a business or a profession? Do they have a stake in the fund’s long-term performance?
One of the most telling tests of a fund manager’s capability is to ask them to explain their investment philosophy as simply and concisely as they can. A fund’s investment philosophy should not be a string empty words displayed on the manager’s website and then largely forgotten. An effective philosophy is regularly consulted to ensure that all investment decisions ae consistent with the fund’s purpose. Your research should examine the fund’s philosophy to see if it is consistent and lived out through its investment decisions.
Is the manager sticking closely to its mandate or is it stretching it too far? Is it remaining true to label and delivering on investors’ expectations, or could it end up surprising investors when the market turns? Does the manager exercise patience and buy/sell discipline, or are they liable to panic? While this is fundamentally a qualitative research exercise, this is one example where quantitative research can play a crucial supporting role. For example, Lonsec considers key valuation metrics, performance across differing market conditions, and output from style research tools using holdings-based style analysis software.
Once the soundness of the investment philosophy has been established, the next step is to ensure that the fund has a robust process in place to identify securities and incorporate them in their portfolio. This involves everything from the idea generation process to the intellectual property and software used to value assets. If the size of the manager’s investable universe is very large, what process do they have for narrowing down their list of potential opportunities? What attributes are they looking for when searching for the right stocks, bonds or properties?
What macro or market themes are they looking to take advantage of? How do they carry out their fundamental analysis and what valuation methods do they use? Do their people and systems have the appropriate breadth and depth to carry out their research process? Lonsec typically requests that managers explain multiple investment theses as a means of demonstrating the investment process at work and gauging consistency with the fund manager’s stated investment style and objectives.
Partnering with a research house to achieve in-depth qualitative research at scale
Developing an effective qualitative research model requires a lot of work, but the real challenge is in supporting the process with the right people and resources. Most investors don’t have the data or the capabilities to be carrying out in-depth qualitative research at scale, which is why they partner with a research house like Lonsec. For investors committed to generating long-term outperformance, a world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.