Dig deeper to unearth cream of funds crop

The challenges associated with selecting funds and managers are multifaceted, and there are a variety of methods engaged by fund selectors to overcome these, ranging from simple performance screening to full in-depth due diligence.

At the most in-depth end of the spectrum, a dedicated manager researcher’s goal is to identify those funds or managers which will meet or exceed their investment objectives on a forward looking basis. This involves rigorous analysis and a deep understanding of how the portfolio manager invests and why. 

Analysis of past performance is an important part of this, but should not be relied upon to extrapolate future performance expectations. The data can be used to aid the researcher’s understanding of the investment philosophy and process, and to confirm whether the portfolio manager has adhered to this, and whether indeed they have any skill at it. 

However separating luck from skill is extremely difficult, and there is some evidence to suggest it takes seven to 10 years to differentiate between the two on a statistical basis. Many emerging opportunity sets do not provide for that length of look back period. Therefore it is often more of an art than a science, and researcher experience and a thorough understanding of investment styles becomes more important than quantitative analysis.

Beyond the bluster

This brings us onto another challenge facing the researcher – looking through portfolio manager charisma and spin to identify whether there is any substance and rigour behind what they do. Portfolio managers, on the whole, tend to be bright and confident individuals and are generally fairly convincing when they explain the reasons behind one investment or another. Whether or not there is a solid basis to their analysis and whether this is repeatable are the critical questions to be answered. 

Beyond the issues of idea generation and manager skill there are also a variety of issues to be investigated surrounding portfolio construction and implementation of the portfolio. While idea generation creates alpha opportunities, portfolio construction and implementation is where alpha can be lost. Spending time looking at the approach to matters such as capacity management and trading capabilities is important, while looking into risk controls and portfolio construction guidelines is critical.

Last but certainly not least the firm itself also needs to be assessed. Is it a conducive environment to get the best out of the investment professionals running the fund, is staff retention strong, how well aligned is the team and the firm to the end client? All of these play into the likelihood of a fund meeting its objectives.

With so many aspects that should be considered when selecting the right fund, it can be time consuming and labour intensive work. This inevitably leads some advisers to use simple performance screening in order to select funds for clients. Indeed it can be extremely difficult for an adviser to convince clients to buy a fund which has not generated strong recent performance. 

However, basing investment recommendations on past performance alone is extremely risky, as we all know past performance is not necessarily a guide to the future. Furthermore, explaining underperformance to a client in the future is difficult when you do not truly understand the reasons behind it. 

While full in-depth due diligence may not always be feasible, a review of some of the important aspects mentioned above is vital. There will always be a balance to be struck between depth of review (and therefore confidence level) and cost/resource requirements. It may not always be possible to have a team of manager researchers on staff, or even to commission this level of research from an external provider. 

A qualitative review, to some degree, should be considered and can provide the adviser with the understanding they require to advise their clients with some confidence. A short but effective desk-based review can help advisers to be able to more insightfully discuss the fund with their clients. It could also help them to be able to explain performance in the future, with the aid of some quantitative analysis. 

The further along the spectrum – from simple quantitative analysis to onsite investment due diligence – the greater the degree of conviction an adviser can have in advising their clients. Advisers looking to distinguish themselves in the quality of their service offering should be looking for something more than simple performance screening in order to guide their clients. 

A succinct but pertinent qualitative assessment, where the parameters are well thought out, coupled with simple performance analysis can provide a sound, cost effective method for selecting funds.    

Beverley Sharp, global head of retail research, Mercer