There's an old saying in investment management consulting: If you want a clear picture of a manager, look at him during a bear market.
Evaluating, selecting and monitoring managers requires sound judgment and significant due diligence; it is part art, part science. Most consulting firms research managers and generate lists of approved ones that advisors can use to guide them in choosing managers for their clients. Of course, many advisors prefer to handle their own manager search and selection, and these tend to be intimately familiar with the best indicators of a manager's performance.
But even those who rely on consultants for their manager ratings should have an idea of how those are compiled, because many clients want to hear what went into the choice of a particular manager, and it behooves an advisor to respond with something beyond, “A consultant said this one's good.”
Here are five critical questions to ask any manager you are considering for your clients, according my colleague, Don Trone, president of the Foundation for Fiduciary Studies.
What are the true performance figures? Ask for both retail and institutional performance figures. If the numbers are different, ask why.
Who will actually manage the account? Find out which manager will handle your accounts. For any track record you're shown, ask who created that record. Is it the same person or team that will be handling your clients' accounts? Often, one team handles retail clients, while another handles institutional.
What are the trading procedures? Will your clients' trades be included with those of the manager's institutional clients?
When will your clients be fully invested? Find out how long it will take the money manager to invest your clients' funds fully into the market. Determine whether this strategy meets your clients' expectations.
What particular tax-advantaged strategies are used? Many managers say they offer tax-sensitive trading strategies; you need to ask for specifics.
Tax-advantaged strategies may include purchase of low-dividend-paying stocks, year-end harvesting of losses, low turnover and selling first of highest-basis shares. Remember, of course, that the best after-tax returns can begin with the best pre-tax returns.
Keep in mind that each client's investment policy statement is the ultimate guide to finding the best money managers for the strategy you have in mind for them. Too many times advisors doing their own searches put too much emphasis on manager selection and not enough on the overall investment structure.
Number Crunching 101
The data associated with manager evaluation can be overwhelming — and often more trouble than it is worth. But you must be familiar with the most important measures and how they add value to the process:
The first measure is Return on Investment (ROI). This has two aspects — time-weighted measurement and dollar-weighted measurement. Time-weighted measurement takes into consideration the time value of money over an accumulation or specified period. It is important in gauging manager effectiveness and disregards the effect of the timing of cash contributions or withdrawals. Dollar-weighted measurement focuses more on the client's goals. It uses simple dollars, in and out, without consideration for the time value of money.
The second important measure is standard deviation, which is the measurement of how far the price of a market, security or portfolio is expected to deviate from the norm. The standard bell curve shows the relationship of this measurement to the normal expected range of the entity. Statistically speaking, approximately 66 percent of all events are within one standard deviation of average. Approximately 95 percent of all events are within two standard deviations of average.
Is that too heady? The concept is related simply in a story from my colleague Don Berryman, of the Chartered Institute of Management Accountants (CIMA):
My mom is considering a retirement move. She can't tolerate temperatures above 100 or below 40 degrees. Some cities experience extremes — snow in the winter or 100-plus temperatures in the summer, so this parameter would eliminate the cities of Phoenix and Chicago. But which is more likely to please her — Dallas or San Diego? A standard deviation analysis can help. The average temperature for both cities is 65 degrees, but the standard deviation in Dallas is 20 degrees and 10 degrees in San Diego. Using our knowledge of standard deviation we might determine that there is a:
66 percent chance of the temperatures staying between 45 and 85 degrees in Dallas (average of 65 degrees plus or minus 20 degrees standard deviation)
66 percent chance of the temperatures staying between 55 and 75 degrees in San Diego (average of 65 degrees plus or minus 10 degrees standard deviation)
95 percent chance of the temperatures staying between 45 and 85 degrees in San Diego
95 percent chance of temperatures staying between 25 and 105 degrees in Dallas
San Diego, then, looks like the better choice.
When making your final selection of managers, use quantifiable measures such as the ones outlined above, to document that decision. Objective measures help your clients understand why you selected their managers.
Again, even if you are not part of the evaluation process, it's good to know all the components in a successful search. Your clients will be impressed by your knowledge and the care with which you handled their assets through your value-added process of consulting.
Steve Gresham is executive vice president and chief sales and marketing officer for the private client group of Phoenix Investment Partners, Ltd. He's the author of The Managed Account Handbook: How to Build Your Financial Advisory Practice Using Separately Managed Accounts and Attract and Retain the Affluent Investor: Winning Tactics for Today's Financial Advisor. [email protected]