How to pick the right investment manager

Dominic McCormick explains that when it comes to investing, the process is much less important than the character traits and the experience of the people who are making the decisions.

When it comes to active investment managers I have always believed that it is people, not process, that matter most.

One can make the case that for some quantitative investment managers, process is more important — but even then, the key role of people in developing, running and enhancing the processes is often understated.

But for your typical active qualitative investment manager, whether picking stocks or making macro/asset allocation calls, it largely comes down to the ability of the people involved.

Of course the large brand name fund managers will try and tell you differently, and it is in their interest to do so.

They don’t want their investment management brand hostage to one or two key people. Some can even attract and develop the right people and produce good performance for extended periods, although this is rare.

The key problem is that only a small proportion of participants in the investment industry will become excellent investors.

Beating the market consistently is not easy, not because the market is efficient, but mainly because all investors are subject to the behavioural flaws that create market inefficiencies in the first place.

If one accepts this, then understanding how excellent investors emerge and seeking clues to identify them is crucial for anyone involved in selecting fund managers (multi-managers, researchers, consultants, some planners etc).

Further, to the extent that these participants themselves are making asset allocation/thematic calls they need to ask whether they have the appropriate skills to be doing so.

This brings us to the question of whether good investors are born or made. As with most nature/nurture debates, I believe it is a combination of both.

Interestingly, a study of Swedish twins by Barnea, ConQvist and Siegel (2009-10) suggested that the genetic factor explained around one third of key investing behavioural characteristics (such as stock market participation and asset allocation).

Even twins who grew up separately had similar investing traits.

While not indicative of future investment success, it does suggest that genetics does impact elements like risk taking that might form the basic platform for potential future investment success.

Obviously, there also has to be a reasonable level of intelligence.

While studies have shown that the higher the IQ a person has the more involvement they have in stockmarkets, this does not automatically translate into stockmarket success.

Indeed, in my experience, some of the smartest people around make terrible investors.

I suspect this is because they approach investing thinking it will be easy, have little patience, refuse to learn from others and go ahead to make every behavioural mistake in the book.

Some very smart people also become believers in efficient markets — their argument perhaps being that ‘if someone as smart as me can’t beat markets then no one can’.

Then there is the related question of qualifications. A cynic might suggest that formal finance qualifications are a negative factor as they often teach flawed/ outdated theories and historically have emphasised the efficient market view.

On the other hand, it is important to understand the mechanics of markets and what participants are up against.

In any case, if someone doesn’t come out of a formal finance/economic degree without some serious issues/questions with how those disciplines see the real world then the chances of them becoming good investors are remote.

In practice, successful investors seem to cover the spectrum from those without any formal qualifications to those with PHDs (and not necessarily in finance).

Practice makes perfect

If genetics has a one third say in our basic investment characteristics, and a reasonable but not exceptional level of intelligence and qualifications is necessary, then what makes an excellent investor over an average or poor one?

I think it comes down to Malcolm Gladwell’s comment in his book ‘Outliers’ that success in a whole range of fields is about serious and sustained effort. It has been defined as someone who devotes at least 10,000 hours practising their chosen discipline.

Making mistakes and learning from them is clearly a vital part of such practice.

However, even before this, one needs the passion (some would say ‘obsession’) to devote the time and effort in the first place.

Typically in the investment field this shows up through an interest in markets and investments at an early age, perhaps aided by interest from someone within the family.

Once hooked, they tend to develop a thirst for knowledge and information on the area even before they have any serious money to invest.

Ultimately, in fact, they are not in the investment business for the money. Money is simply a way to keep score.

Of course, Gladwell says luck and being born at the right time also determines success, and that is also clearly true in investments.

In an extended bear market (say Japan for the last two decades) you will find fewer investment ‘geniuses’ than in those countries experiencing a secular bull market.

One key difference with success in investments compared to many other fields is the need to think for yourself. In investments, if all you develop is widely held views then you can be pretty sure those views are already reflected in the markets.

Thinking independently and often contrarily is, by definition, not natural in the general population.

Having said this, it is important that they have a degree of flexibility — markets are dynamic.

Those with a permanent and extreme bearish or bullish predisposition will be seen to be brilliant occasionally but will miss many of the best investment opportunities over time.

This all suggests that good investors can be trained, but only if they have some essential characteristics and the passion to start with (and they start reasonably early).

Good investors become more instinctive as their experience grows. They seem to know when an opportunity is presenting itself and when the market is getting something badly wrong.

An idea typically gnaws at them until the pressure to do something with it becomes extreme. If you want some excellent examples of this, read ‘The Big Short’ by Michael Lewis.

I think there are some similarities with top athletes, particularly where there is a degree of complexity and skill involved.

Some athletes seem to have an exceptional ability to position themselves or time a play.

There may be an element of natural (genetic) talent but it is more likely the result of practising something so much (and making plenty of mistakes along the way) that it becomes instinctive.

If you asked these athletes to explain exactly how they do this with the aim of transferring this skill to others, they either can’t answer or come out with some sort of useless gibberish.

Good investors are often the same. They can analyse a stock, valuations or industry/macro issues but often they can’t quite rationalise why they like one situation much more than another that may look similar on more objective grounds.

Further, they can sense when the market is providing a particularly good opportunity to get set in a stock or an idea and when the market has become excessively exuberant.

Good investors need plenty of flexibility in these situations.

While it is essential that their ideas be challenged by colleagues and that the risk management framework around the decision be sound, if they are prevented from pursuing an idea until its rationale can be fully presented in an easily explainable fashion then much of the opportunity is probably already gone.

Picking managers

One needs to bear the above in mind when assessing fund managers.

Some of them do a poor job of explaining what they do and how they do it because a big part of what they do is intuitive.

There is therefore a need to focus on the right ball here — it is judgement on likely risk adjusted returns going forward that matters — not how good their presentation is.

Of course, this is not to say that they don’t make mistakes. Indeed, it can sometimes be their highest conviction ideas that are most wrong, perhaps because they develop a tunnel vision on these and neglect peripheral risks that cause them to go awry.

In fact, I think there is a tendency for one’s highest conviction ideas to turn out to be either the best or worst investments — rarely do they end up average.

This has implications for portfolio construction. While somewhat concentrated portfolios make sense, those with only one or two key themes/ideas — even if spread across a number of stocks — are probably not a great approach in most circumstances.

Indeed, some excellent investors themselves are also often agnostic about which of their ideas are likely to work out best over time.

I recently read Sebastian Mallaby’s ‘More Money than God, Hedge Funds and the Making of the New Elite’. Terrible title, but the book provides an excellent history of hedge funds and some of the great investors in that space.

The thing that strikes you is how little process was behind some of this great success and how dependent the success was on key individuals.

It even suggests that superior (and secretive) quantitative managers such as Renaissance Technologies demonstrated a remarkable flexibility to change the direction of their research/models totally on the hunch of key individuals.

But even great investors can go bad. They can lose the passion, have life problems which interfere in their investing, or more conventionally simply end up managing too much money for their edge to shine through.

Further, major bull markets create many investor heroes that benefit from a rising tide but look seriously underdressed when the tide goes out.

So what does all this mean for those picking fund managers and asset allocators? Well it implies that some sort of box ticking or weighted model approach to assessing them has limited value.

Yes, it is necessary that the elements that these approaches cover (business issues, technology, processes etc) stack up, but if the investment people don’t add up all of this is largely meaningless.

Process is important to create a framework where the skills of good investors can come to the fore. It is also important to ensure the infrastructure is there to deal with the investment and non-investment risks that fund managers face.

But too often process is driven from a marketing perspective and the attempt to demonstrate a robustness, which is beyond the way good qualitative investors should (and do) work.

Process-obsessed fund managers (outside quantitative managers) often result in decision-making that is excessively committee/consensus driven, a lack of necessary creative thinking and a culture where delivering on the process is seen as more important than delivering good risk-adjusted investment returns.

How then do researchers, investors, planners and multi-managers make decisions about who to employ given these complexities?

It is certainly not easy, especially given the difficulties of getting to know anyone properly in a few short meetings.

Alternatively, blindly projecting from good past performance is dangerous — although assessing how performance was achieved through different market environments can give some understanding.

Reviewing some successful (and unsuccessful) investment ideas can also give an idea how they think and act and whether the key people have an edge that is sustainable.

One can understand why some investors just give up and just go for a spread of index funds, even when they don’t believe in efficient markets.

Indeed a sensible well-diversified passive approach (not necessarily index) is certainly better than a half-hearted attempt to package together active managers (or pick stocks) focusing on brand name or past performance alone.

But excellent investors do exist and can be identified — and the process of trying to find them can make you a better investor.

It is a task worth pursuing? We believe it is. Just make sure that you or the people you are employing to do it have been doing so for at least 10,000 hours first.

Dominic McCormick is chief investment officer at Select Asset Management.