How To Choose An Investment ManagerGary Mishuris, CFA
Many of you don’t need an investment manager. Others are paying hefty fees for a service different than the one you think you are getting. Before giving up a good chunk of your future wealth, consider what your actual needs are before deciding how to proceed.
“You: Identity, Anxiety, Money”
The above quote is the heading of the first part of an investment classic from the 1960s, The Money Game by ‘Adam Smith’. The point is that your identity and your anxieties are frequently more important than money and determine how you approach it. In my career as a value investor friends have frequently come to me for financial advice. I have found that people’s underlying needs and desires can be broken down into three categories:
- Financial Planning – You have complicated future needs for your capital that involve different time horizons. You need someone to sit down with you, understand how and when you intend to spend your money, and come up with an investment plan that matches the time horizon of your current and future wealth with how you intend to spend it. Perhaps an annual follow-up meeting would be helpful to make sure you are on track and that your goals have not changed.
- Hand-Holding – You might know what you should do rationally with respect to your investments, but have trouble staying the course when the financial markets move to either extreme. I have a very smart friend, and every time the stock market is close to a peak he calls me and asks if he should sell all his bonds and buy more stocks, and every time we are at the trough of a market downturn he asks if he should move his whole portfolio into bonds. If this is you, the main thing you need is not some clever financial strategy, but someone who will save you from yourself; you need an external voice to get you to adhere to your financial approach consistently, regardless of temptations to deviate.
- Above-Market Investment Returns – Who wants to be average, right? Plus, aren’t you discerning enough to spot the superior investments or investment managers to get you to a market-beating rate of return? Maybe. However, most of those who try end up with below average returns. The most shocking statistic I have come across in my almost two decades as a professional investor is not that the average investment manager underperforms the market by the amount of the fees that they charge; that’s to be expected. It’s that the average investor in a mutual fund underperforms the returns of that mutual fund by 2-5% per year. How? They buy high and sell low because they use the wrong metric (hint: trailing performance) to decide whether to invest with a manager or to redeem.
There is a good chance that you are not getting the service you think you are paying for
Let’s suppose you decided that all you need is help with financial planning. You should go to a financial adviser, right? Well, not so fast. Financial advisers are not keen to charge you a flat fee for the financial plan and for the time to meet with you afterwards. They would much manage your money for you for a 1% permanent equity stake in you.
What makes them deserving of such a bounty? Many don’t even try to produce above-average performance. Of those who do, a good portion does it half-heartedly and with little chance of success; they own a basket of large, well-known “blue chip” stocks and bonds that they know will be familiar to their clients and that they hope their clients will not blame them for if they don’t do particularly well. After all, how poorly can you possibly do investing in such icons of American industry as General Electric?
That’s not to say that there aren’t some very good investors among financial advisers. However, many of them spend most of their time on business development and client service. If you have a $3M portfolio, should you really be handing over $30,000 a year to someone for punching in your financial information and goals into a financial planning software package, customizing the financial plan a bit and then spending at most 10 hours a year with you while investing your capital in a middle-of-the road collection of securities? Let me put it differently: what would you expect from someone if they told you they would bill you at $3,000+ per hour? Hopefully a lot.
Don’t fall for investment managers substituting high-touch service for performance
Providing a high-touch, personalized service to investment management clients is far easier than generating superior long-term investment returns. The former can be easily accomplished through effort. The latter requires skill, experience and temperament that history has shown most do not possess.
How much would you be willing to pay for a nicely dressed person to meet with you 2-4 times a year, chat about your family and interests for 15 minutes and then spend the next 45 minutes on an overview of the market and how your investments are being handled? If instead of hiding the fee as a small percent of a large number (e.g. the standard 1% of assets under management), they actually sent you a bill for those meetings for you to pay out of pocket, what would you be willing to pay?
Separate that in your mind from their investment results for a second. Would you really hand over tens of thousands of dollars just to have those meetings and have the red carpet rolled out for you? If the answer is yes, there is absolutely nothing wrong with that. Many however would balk at paying such huge sums just to be treated nicely a few times a year when coupled with investment returns that are worse than what can be obtained through a low-cost passive index portfolio.
You should be clear about the value that you are getting for your fee. Consider this: if you compound $1M for 25 years at 8% you would end up with $6.8M. If you instead compound it at 7%, taking out the 1% fee for your investment manager, you would only have $5.4M. The difference, $1.4M, is quite a lot to pay just to be treated nicely a few times a year. If that is worth it to you, that is fine, as long as you understand what you are paying for.
When is the high fee worth it even if the investment manager doesn’t try to beat the market? A good example is if you are the kind of person who needs hand-holding to stay the course. I have a relative who is very smart and is close to retirement. He recently received a large sum of money that constitutes the vast majority of his retirement nest egg. While quite sophisticated in many areas of life, his knowledge of finance is modest. Naturally, he is very nervous about losing the money, and for him the hand-holding and the mental comfort he derives from the personalized explanations and service could very well be worth the high fees. He is paying for the peace of mind that it brings him, not because he has unrealistic hopes that he will achieve above-market investment returns.
Identifying investment managers who will produce superior returns is hard
Here is how not to do it: look at each manager’s trailing 3 year performance, and invest with the ones who have done well over that period. Why? Because there is no persistence of results and managers who do well over a 3 year period will not necessarily do any better than average (and frequently far worse) over the next 3 year period. How about those “stars” that almost every investment firm touts when they market their funds? Sorry, those also don’t correlate to meaningful superior future returns.
So if the above is true, why is the standard industry practice to sell funds with good recent (1 to 3 year) performance and advertise the 4- and 5- star funds prominently? Because it’s an effective way to sell and make money for the investment managers, not because that is what is best for the clients. The industry makes way too much money doing this to ever say “gee, we noticed there is no statistically significant relationship between what we use as our biggest selling points and future results, so we won’t do that anymore.”
Behavioral marketing works – people want to be associated with winners, even though that tiny print warns them about the irrelevance of past performance. So does social proof, large advertising budgets and other tactics. Unfortunately those things cannot buy superior long-term results. For that you need the investment manager to have the following characteristics:
- An investment philosophy and process that systematically exploits market inefficiencies in a way that is consistent with the manager’s strengths and weaknesses
- The temperament to remain rational and stick to the process when under tremendous psychological pressure
- A structure that has an alignment of interests with the client, which usually means the manager has to be willing to make less money than they could if they just followed industry norms
- A passion for more than just money – intrinsic motivators that will reinforce the above
Here is the thing: if you cannot assess an investment manager’s process and ascertain that you think it is likely to produce superior results and then monitor that the manager is sticking to it, chances are you are better off with a low-cost, passive investment. Let’s use the analogy of a car. You don’t need to be able to make your own car or fix the engine if it breaks down, but you better know what the different lights on the dashboard mean.
For many, understanding the process the manager is using and then monitoring it is either beyond their financial abilities or is simply not a good use of their time. If that’s the case, then don’t hire an investment manager hoping for superior performance. How are you going to decide with whom to invest? Based on that trailing performance the industry would love for you to use? We already know how well that works.
Get what you are paying for
Do you want a financial plan but are content with average investment returns? Find a competent financial planner who will charge you a fair fixed fee and then hand over the money to a reputable low-cost index fund complex.
Do you need high-touch service and hand-holding to ease your mind? Then find a financial adviser who will provide you with that, but know that you are likely giving up a good chunk of your wealth.
Do you want to get market-beating returns from your investment manager? That’s hard. Unless you can assess the manager’s process and monitor that they are sticking to it, your odds of beating the market by selecting investment managers are poor. If you aren’t sure you have the ability to assess their process, there is nothing wrong with admitting your limitations and going the low-cost passive route. Chances are, many people who are currently invested with active managers would have higher after-tax results if they were to switch to low-cost passive index funds and stick with a consistent plan.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
Note: An earlier version of this article was published on Forbes.com and can be found here.
Article by Gary Mishuris, Behavioral Value Investor