Multi-managers snare for the unwary

T he acute meteoric growth of multi-manager investing over the past 10 years has resulted in some very successful strategies, along with some very poor, misguided attempts. The growth of this sector was driven initially by the growth of funds management and the ever-increasing choice of fund managers in every asset class.

As the manager of such a fund, I have found the challenge of running an atypical approach to multi-manager investing is more to do with one’s original motives while enforcing a common sense approach.

But let’s first take a step back. Funds management in Australia has grown beyond the demand for specialist professionals to run portfolios of shares, property, fixed income or cash investments in a single easy-to-administer investment vehicle.

This approach became increasingly popular as the retirement savings boom, coupled with a bull market that began in 1982, fuelled the explosive growth of investable assets. Today, Australia stands as the fourth largest managed investment market in the world with over $1 trillion in assets. This is an extraordinary achievement given Australia’s population of just 23 million. The US’s population is 330 million; India has 1.2 billion people while China’s population is 1.3 billion.

Look for value and beware the ‘asset gatherers’

In a growth industry with strong momentum it is perfectly understandable that a range of multi-manager approaches will emerge. A primary point here that investors must carefully consider is who is promoting the multi-manager product, as some providers will only survive if they provide competitive performance.

On the other hand, some product providers don’t need high performance and simply offer a compelling marketing story to cater to a large distribution base. The industry knows such providers as asset gatherers. And the last thing an asset gatherer needs is for performance to stray far from the median. That may suit some investors, but not others.

To achieve mediocre results, asset gatherers simply implement a very high level of diversification, in a way almost mimicking the overall stock market. Think of it this way — an investor gives their hard-earned retirement savings to a multi-manager to invest in Australian shares.

The multi-manager uses a well articulated pool of fund manager products, ensuring they have blended manager styles, and each manager is benchmarked against the ASX All Ordinaries index. They may use up to 10 or more fund managers, which each hold over 50 stocks. In this scenario, an enormous level of overlap develops, while the ultimate portfolio appears remarkably similar to the overall index.

The poor investor is left with a holding in an insane and costly level of product complexity, which could probably have been avoided had they just bought 20 blue-chip Australian company shares directly or allocated funds to one or two fund managers directly.

Separating marketing myth from common sense

Let’s start with the absolute return and balanced fund space. In this area, the most important decision a multi-manager will make is not manager selection but asset allocation. In other words, deciding which assets to buy and how much of the portfolio to allocate to each. Manager selection is nowhere in sight at this stage of the process.

To come to a sensible conclusion on asset selection and the weight of each asset, an assessment and view needs to be made on the underlying attractiveness of each asset class over the next one, three and five years. To do this, the multi-manager must form a view based on research, respected opinion and investment experience.

Once this decision is made, an assessment of the appropriate fund managers for each asset class is made.

After that, the portfolio manager makes adjustments periodically to keep the portfolio fresh relative to their current view on asset allocation.

An example of this may be a current view to favour asset allocation to shares in emerging markets, corporate

bonds, global growth stocks and global listed infrastructure stocks. This assumes a negative association placed on advanced economies such as the US, Europe and Japan, and a negative view on government-issued fixed income securities such as treasury bonds.

The pitfalls of the ‘black box’ approach

If a portfolio manager does not have the skills to make an active investment call on markets, they will turn to science to do the job for them. Unfortunately, while this has delivered some pretty ordinary results for investors, it is still one of the more widely used forms of investing.

This approach makes elaborate assessment of how each asset class and fund manager has performed to date. It then makes the assumption that in all probability the norm will continue, and hence a portfolio can be constructed with a high degree of confidence on the likely outcome.

The first mistake in this approach is to assume that assets will act in a similar way in the coming period as they have in the previous corresponding period. That’s like operating a car in drive while looking at the rear-view mirror. It might work for a little while on the Nullabor Plains, but it will eventually result in a nasty crash.

It is also misguided to make assumptions about how a manager will perform going forward based on analysis of their style and historical performance. Note the old disclaimer that past performance is no guide to future performance.

I would argue that the best way to select a fund manager is to spend the bulk of your research time on assessing the manager’s view on markets going forward and their plans for stock selection on that basis.

Forget the past, the past is history. You can only buy what a manager will do for you in the future. If you don’t agree with their assessment or have doubts about whether they are not on top of their game, take evasive action.

Never be tempted to choose managers based on table-topping performance over the past 12 months.

The travails of benchmark hugging

The final area of controversy worth discussing is benchmarks. How often do you hear about benchmarking managers to assess their ability to outperform.

I am still amazed by data vendors that continue with monthly performance tables for fund managers who are charged with managing funds with three- to five-year time horizons. It just does not make sense to judge the ability of a marathon runner every one hundred metres. It’s simply a waste of time and effort.

If that’s not bad enough, the use of index benchmarks and index funds must go down as one of the all-time greatest mistakes. To use the ASX All Ordinaries index as a basis for comparison, for example. Many fund managers are benchmarked against this index for running a portfolio of Australian shares they believe represents a sound investment for retirement savings.

This index has been used because it represents the overall value of the Australian stock market and is measured on a daily basis. It consists of over 300 companies and is compiled with the largest company representing the highest weight in the index down to the smallest representing a fraction of one per cent. The critical point to note here is that nowhere in the literature published by the Australian Securities Exchange is there any mention of the index being compiled or presented as a list of companies in which investment is worthwhile.

In other words, there is no attention paid to the quality (or lack thereof) of any company represented in the index.

Any person who has had even a minimum of investing experience knows that the stock market is made up of blue-chip companies along with some very risky, poor quality companies. Investing in index funds guarantees an investor one thing — they will be investing in poor quality companies.

The same may occur if fund managers are harassed in short timeframes as to why they vary from the index, especially if their performance is below the index’s median.

This harassment can lead to managers making poor short-term investment decisions.

In summing up, be careful of multi-managers who use too many fund managers in their lineup, and don’t be fooled when promoters say they can select ‘the best managers’ or ‘closely monitor managers’.

No one can predict who the best manager is going to be over the next 12 months. But an experienced investor can assess if a manager’s view of the market and stocks is sound, and this simply makes sense given the current environment.

Keeping on top of that equation will be a valuable use of your time and effort compared to

following an outdated academic approach to manager selection.

David Cooper is chief investment officer with multi-manager listed investment company, Premium Investors.