International equities - what you need to ask a fund manager

This month, PortfolioConstruction Forum asked the research houses: “You are making the final decision as to whether to recommend an international equities fund - what is the one last question you would ask (or ask again) of the fund manager, and why?”

Lonsec

A good question to ask would be: “Why do you believe you can meet or exceed the fund objectives?”

This is a catch-all question, but should provide a consistency check, particularly in terms of answers the manager would have already provided around people and resources, research approach, corporate structure and the ability to deliver an appropriate reward for risk.

Linking this question back to current portfolio positioning should also provide an indication of how insightful the manager has been over the period since the last review, and whether the manager is adhering to its process and remaining true to label.

Of course, the reality is that there is no single last question that will determine the decision to recommend an international equities fund.

Ultimately, Lonsec aims to make an assessment of whether a fund can provide consistent long-term performance above that of its benchmark and peer group.

We believe a manager’s ability to do this can be distilled down to having the right people, in the right environment, supported by a logical and robust process.

Mercer

The final question to be re-asked is: “Can you identify what your competitive advantage is and how your investment process exploits this opportunity?”

The reason we ask this question is that it is nearly as important that a manager understands where they have an edge (and where they are directing their efforts) as having an edge in the first place.

If the manager does not understand this feature of their investment proposition, they are just working hard but without a clear focus.

There are a number of ways in which Mercer believes it is possible for a manager to add value, including:

• Superior knowledge to other market participants;
• The willingness to take a long-term view when other market participants are not, and are overwhelmed by the noise of more recent news flows. (Does not preclude strategies with a shorter-term time horizon being rated highly), and;
• A better understanding of behavioural factors than a typical market participant.

Morningstar

The question would be: “What is your competitive advantage?”

The reason for asking this is that it is an open question, and gives the manager great scope to answer on a number of levels should they so choose. The approach taken to responding, and the answers they give, can be revealing and instructive.

It is also instructive of our qualitative approach to research in delivering a holistic view of a manager’s capability.

Each manager should be able to clearly explain the areas of particular strength they believe give them an edge.

This could be across a number of areas such as analyst insights, team tenure and experience, portfolio construction, proprietary models, investor alignment, or a combination of these and other factors.

In the absence of a sound rationale, we would question whether they have the belief in themselves to deliver excess returns over the medium to long term.

Some fund managers also mention their weaknesses in the same response, which may highlight a balanced approach and a desire to improve.

Therefore, it will highlight any difference between their perception of themselves and the reality in which they operate in. It gives an insight into their culture.

Standard & Poor’s

From an investment strategy selection perspective, the key considerations are covered off in the manager due diligence review, and strategy review processes.

However, assuming all is satisfactory and the due diligence review validates the strategy, we would revisit the following questions:

“Does the strategy have an alpha-generating thesis that can be validated in at least one economic cycle; has the manager demonstrated consistent and reliable alpha generation through the implementation of a repeatable investment process; and is the alpha opportunity being considered the one that has actually produced the alpha for the strategy?”

All other things being equal, the answers to these questions are the core consideration in the fund/strategy selection process.

Consequently, it is imperative for portfolio construction to fully understand and have confidence that these aspects of a fund/strategy are able to generate alpha as intended.

van Eyk

The final and most important question to ask is: “Can you communicate your strategy to clients in such a way that they will stick with you in sickness and in health (at least in terms of performance)?”

The obvious attributes of strong people, process and business are by now minimum investment grade criteria. It should also be taken as a given that a highly rated manager has a tangible edge in the market (a surprisingly rare attribute).

Much better investment outcomes are generally achieved when clients are placed with managers they identify with at a level deeper than implied by branding, past performance or a weighty research report.

We all stand a much better chance of making sure clients have the patience to let the manager exploit the investment hypothesis if the thesis can be communicated to and internalised by investors.

If they lack belief in a manager, they will find it even more difficult to stick with those who have a more active investment strategy.

It should also be noted that the impact of ill-timed switching can easily swamp the potential added value from good manager selection.

Zenith Investment Partners

The short answer, after reviewing all other aspects of the manager and fund, is accountability – who is ultimately accountable for the investment portfolio and performance of the fund?

In Zenith’s opinion, it is critical that there is a single person, usually the portfolio manager, who is responsible for the fund, and therefore is ‘on the hook’ for its performance.

It is quite common, particularly with large, US-based global equities managers, for stock selection and portfolio management to be managed by a committee.

In our view, a committee or multiple portfolio manager approach rarely works, as no one person is fully responsible or accountable for the management of the fund.

In many instances, the Australian-registered global equities fund invests into a portfolio of global equities managed for US or other globally-based investors.

We prefer to see an experienced portfolio manager responsible for the fund managed for Australian investors – and on top of and accountable for its performance. This tends not to be such an issue with the Australian-based global equities managers, where the investment team is much smaller.

Nonetheless, it remains critically important that there is a dedicated portfolio manager responsible and accountable for the performance of the fund.