Top 400: Not so hasty: Keeping a manager when the going gets tough
The perennial question – should I sack an underperforming manager? – came up the other day and it got me thinking about the state of our industry. My first reaction was how little things have changed over the decades: we’re still hiring managers who have outperformed and sacking those that have underperformed. This is despite all the academic evidence that shows that this approach has consistently destroyed value, as the performance of these managers crosses over soon after the switch: the sacked managers tend to recover strongly and outperform both the market as the newly appointed manager struggles.
It struck me that it is not just asset owners who are faced with the difficult decision of what to do with their ‘losers’, as managers have to contend with this problem perpetually. The average number of outperforming stocks is close to 50% for fund managers, and even the best only have 54% of their stocks outperforming in any given month. We have found through working with fund managers that the decision on what to do about a loser is a cocktail of analytical process and behavioural responses.
On the analytical side, the decision comes down to whether the original thesis was correct. Sometimes it is and sometimes it is not, and the skill is to be able to distinguish one from another. However, our research has demonstrated that even the best investment managers succumb to their behavioural biases; few of them want to admit to their mistakes and crystallise a loss. The best are able to keep the emotional side under control.
To return to the original question about what an asset owner should do when faced with this difficult decision, ideally the same framework should apply, where the best decisions are arrived at through an objective process and where behavioural and emotional influences are recognised and accounted for. So what are these analytical processes that asset owners should apply?
In my opinion, it comes down to being able to be satisfied that there are good answers to the following questions: is the manager doing what they say? Are they good at it? And are the timings of their decisions right?
It is rare that fund managers don’t do what they say but it is one of the vital things that you really do need to know about if it is the case. For instance, if a manager says they are a contrarian then turn out to buy stocks with strong prior momentum then there is a problem. Andrew Carnegie put this best when he said ‘as I grow older, I pay less attention to what men say. I just watch what they do’.
Applying this simple philosophy to the assessment of fund managers involves setting up a framework for establishing the key things that the fund managers say they do, ideally at the time of the appointment. Then have a systematic process to check that the decisions being taken are consistent with the provided description of the investment process. Apart from helping to answer this problem, it would send a signal to managers that you mean business. Clearly if the manager was continuing to do what they say, then that would be a tick in one of the three boxes and would allow you to focus on the next two.
Answering the second question – are they good at it? – is more often than not the real stumbling block as it is difficult to remain objective when faced with a poor set of performance numbers, even though we know them to be poor guide to the future. We only have to look at the disclaimers, guidance from regulators, and academics’ literature on the topic to see that it measures what happened in the past, not what is going to happen next, and says little about the skills that produced it. After all, poor results can come from skilful managers who have been ‘unlucky’ in the short term. So the question as to whether an underperforming manager should be sacked fundamentally comes down to whether the recent poor results were down to something other than a lack of skill.
Addressing the question of identifying skill rather than returns requires a clear sense of what skill looks like. For us, this means the ability to find winners and to know when to sell. For example, if the manager had not been successful at finding winners through time, then clearly this would indicate a lack of skill. However, if they had been good at identifying winners in the past, but have recently been less successful then this could be as a result of change in the market, leadership or team members. Shifting the focus from the results to the investment process strengthens the analytical part of the decision and helps keep the emotional reaction to a poor set of numbers in check.
The third question concerns timing, and in our experience this is the one most likely to trip people up. This point is best illustrated by a recent experience. We helped a number of clients with selection exercises of global equity managers during 2007. We found at that time that if the manager owned a portfolio of small growth names then it would have been difficult not to have outperformed. Conversely, if they had owned a portfolio of large quality stocks it would have been impossible for them to have outperformed.
Consequently, the former were at the top of the table and came out well on a three and five-year analysis of performance, and the latter did poorly. We then look to the next five-year period ending in 2012 where we had the complete opposite. All the managers at the top had owned high-quality large cap defensive names, and the owners of cyclical small companies did poorly. Needless to say, some of the managers who were at the top of the tables in 2012 have shown signs of struggling as the economy and the cycle moves into a growth phase. The main message is that performance figures alone are rarely guides to the future, and say little about whether either set of underperforming managers are skilful or not.
So the question as to whether underperforming managers should be sacked really concerns the process for taking that decision. Can you satisfy yourself that the manager is doing what they say, that they know how to find winners and know when to sell, and that recent underperformance is not simply due to time rather than a lack of skill? This is easier said than done, but as always it is worth the effort trying.
Rick di Mascio is CEO of Inalytics