by Cam Hui, Humble Student of the Markets
If investors don't have time or inclination to manage their own money, then the obvious option is to find an investment manager to manage their assets. All too often, they make the mistake of focusing too much on a manager's past returns or how he achieved his buy and sell decisions during the manager selection process.
"Wow! He's a terrific stock picker!"
"OMG! He's been incredible at spotting the next emerging trend!"
Putting the investment process under a microscope
While examining the buy and sell decision is an important part of the process of picking a manager, investors should keep in mind that excellent managers have thoughtful investment processes that do the "little things" right. The existence of a robust investment process is also a sign the manager has taken the time to think about important issues such as risk control, portfolio implementation and creating the organizational DNA to learn from past mistakes.
I would like to explore the decisions that are made after the manager makes the buy and sell decision (which is what we all initially focus on). These other steps are all important parts of how a portfolio is managed. In general, an investment process has the following components:
- Deciding on what to buy and sell (what we spent too much time focusing on)
- Deciding on how much to buy and sell (risk control and portfolio construction)
- Managing the trades (portfolio implementation)
- Review and control (what went right and wrong)
I will not spend time on the first, or the buy and sell decision process. But let me go through 2 to 4, one at a time.
Risk control and portfolio construction
There are many fancy names for this step, such as "portfolio optimization". Without resorting to geek-speak, it all boils down to the issue of once a manager has decided on what to buy and sell, he has to decide on how much to buy and sell.
A good portfolio construction process does two things:
- It controls the intended bets the manager wants to make as part of the buy and sell decision ( for greater context see my previous discussion on Grinold's Fundamental Law of Active Management); and
- It eliminates or minimizes all unintended bets.
How do you what is an unintended bet? Let's say that you follow a high dividend yield strategy and find the portfolio overweighted in Utilities. Is that an intended or unintended bet? If it's an intended bet, then you should control the size of the sector bet and not allow the overweight to dominate the portfolio. If it's an unintended bet, then you should market weight Utilities and just buy the highest yielding ones for the portfolio.
Risks is multi-dimensional and comes in all shapes and sizes. As any good trader or investment manager will tell you, even though you think that you have portfolio risk nailed down, the market will find a way to hurt you in a way that you will not have anticipated. As a result, how a manager constructs a portfolio will be highly revealing of how he thinks about risk control.
In the simplest form, risk may be defined as just absolute loss - and I have met managers who think of risk control purely as where they put the stop-loss orders for their positions. Others will think about risk in other ways, such as in a factor framework (e.g. value vs. growth vs. momentum), diversification (measured by standard deviation and correlation analysis), tracking error against a benchmark (a favorite measure of consultants), macro risk, etc. I would note that since risk is a multi-dimensional concept, managers often think about risk in more than one way.
In addition, investors with very long multi-generational time horizons should consider two sources of risk generally ignored by developed market investors. Firstly, there is the risk of a permanent loss of capital from war and confiscation. Consider that 100 years ago, the major powers of the developed world were Britain, France and Germany, followed by Austro-Hungary and Russia. Up-and-coming "emerging markets" included the United States, Canada, Argentina and Japan. How would you have done if you used either a capitalization or equal weighted approach to investing in these markets and held those positions with no re-balancing for the next 100 years? (Just remember how many people died in very nasty ways in the two intervening world wars and what happened to major developed market governments and markets before you answer that question.)
Another risk to consider is governance risk. How do you know the share and bond certificates that you own are genuine? Even if they are genuine, does the governance framework allow you to exercise your rights as a shareholder or bondholder in the way you expect? Will the courts and the government of the day enforce those rights? While these kinds of concerns are more prevalent in emerging market economies, investors with multi-generational time horizons will have to consider these issues as regime changes can and have occurred with regularity in the past hundred years, even in major developed economies.
Portfolio implementation
I call this step "portfolio implementation" rather than just trading for a couple of reasons. For one, not all managers trade immediately after making their buy and sell decision. Some have to go through an investment committee and the delay can dilute the effects of the decision. Others have such large portfolios that they could not possibly trade their wish list in a single day without moving the market.
Generally speaking, equity trading costs have three components:
- Commission, which is the most visible but usually has the smallest magnitude;
- Impact cost, which can be best explained as the cost of crossing the bid-ask spread, otherwise known as the cost of paying off the HFT pirates; and
- Opportunity cost, or the cost of not trading. What if you placed a limit order to buy a stock but the price ran away from you and the trade didn`t get done. You made the right decision to trade, but the limit order prevented you from executing. In effect, there is a trade-off impact and opportunity cost.
Smart managers usually have ways to measure portfolio implementation and trading costs. One simple technique is to measure the performance of a paper portfolio against the actual portfolio. The performance of the paper portfolio is based on buy and sell decisions at the time that they are made with no commission or other costs. The difference in returns between the paper and actual portfolio is the implementation cost of the aforementioned three components, which can be then be taken apart with further analysis.
I would caution applying the trading cost analytical framework in a simplistic way. There is no one-size-fits-all trading style suitable for all equity managers. You have to tailor the trading style to the reason that you are trading. As an example, classic deep value equity managers tend to be early in their decisions, so it pays to use a patient buy on the bid and sell on the ask trading style. By contrast, momentum traders are transacting on fast decaying information and therefore they should be more amenable to paying up for liquidity in order to trade.
Unfortunately, many investment organizations treat trading as an after-thought and assign their most junior personnel to that function. Such a decision is generally a mistake. To illustrate my point, the gap between a median and first quartile manager for a US equity large cap manager is roughly 100 bp when viewed over a 10 year time frame. Supposing that a manager turns over 100% a year (which is admittedly a little high but not a big outlier) but he can squeeze 20bp per trade from optimizing his implementation process. If achieved, this simple step translates to an improvement of 40bp in performance. That`s practically half the distance between the median and first quartile manager. What's more, all this can be achieved without altering the way the other parts of the investment process, such as how the buy and sell decisions are made.
Review and control
The review and control process is one where the manager tries to answer the question of what went right and wrong in past decisions. Good review and control processes are the hallmarks of a learning organization and an organization that is flexible to adapt to changing market conditions.
While none of us likes to see poor performance, I have found in the past that my greatest insights come from analyzing negative returns. When you invest in an environment where risk is multi-dimensional, the emergence of a new source of risk or blind spot in the investment process can be revealing about the assumptions you have used to formulate your picks and how you have constructed your portfolio.
Many investment organizations engage in some type of attribution analysis. A simple form of attribution analysis for a diversified stock portfolio might be to look for the contributions to performance from sector selection (overweight and underweight decisions) and stock selection. Look for an investment process that goes beyond the simple cookie cutter sector-stock selection attribution analysis spreadsheet template to see if the organization is really trying to learn from their mistakes.
Here is an example that I encountered in the past:
A manager had a US large cap equity mandate. His stock selection model analysis showed that he had an excellent stock picking system. Yet, quarter after quarter, the large cap portfolio underperformed in a way that could not be attributed to "bad luck". Attribution analysis of the portfolio revealed that sector selection was mixed, but stock selection showed a negative contribution on a fairly consistent basis, which was in direct contradiction to the return analysis of the stock selection system.
After much head scratching, the mystery was solved when analysis revealed that the portfolio experienced poor stock selection in megacap stocks (top 100 stocks by market cap), which comprised roughly two-thirds of the weight of the portfolio and benchmark. In effect, the manager found that their stock selection system was not very effective in megacap stocks, probably because that part of the market is highly efficient, but his stock selection process was much better in picking stocks in the large (non-megacap), medium and small cap arena. As a result of this analysis, the manager took steps to address this issue and learned a key lesson about the effectiveness of his stock selection system.
To summarize, the key question an investor wants answered in the review and control process is : "What has the manager done in the past to learn from past mistakes?" It is further revealing of the manager's ability to learn and adapt to market conditions.
Beyond "he`s a terrific stock picker!"
To summarize, I have outlined some of the basic steps to the manager evaluation process beyond the initial investor response to great past performance and the "he's a terrific stock picker!" reaction. These are some simple steps to assess an investment manager, whether he is an investor advisor who puts together an individual investor's portfolio, a mutual fund manager, or more sophisticated family office or other professional investment organization that offers investment services.
To be clear, I am not implying that a manager has to have all of these components in place to be hired. If there is a perceived shortfall in the investment process, it is up to the investor weigh the pros and cons of that manager. For example, an equity manager who uses a research intensive stock picking process and holds a concentrated portfolio of 20-30 stocks will likely not care very much about tracking error against a benchmark (that's for closet indexers!). Analysis might reveal that his tracking error might be as high as 20% (one-standard deviation of 20% variation in return against the benchmark). Such an investment process might be acceptable if the magnitude of manager's stock selection returns overwhelm the riskiness of his portfolio, as defined by tracking error. By contrast, a quantitative equity manager with a highly risk-controlled process who holds a 150-200 stock with a 10% tracking error is likely judged to be unacceptable because of the level of tracking error risk he is taking.
Generally speaking, however, if the manager does the "little things" right, it is a sign that he can be a great manager (even if he isn't a terrific stock picker).
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.
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