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Questions to ask fund managers

For financial advisers and investors the working of fund managers can be a mystery.  Exactly what does a fund manager do – and more importantly, how do they do it?  Part of the issue with understanding fund managers is to know what questions to ask.  

Thursday, July 2nd 2015, 5:50AM

by John Berry

In this two part series Pathfinder provides a framework for analysing fund businesses and the investments they offer.

Why should advisers care? 

Financial advisers have an obligation to provide a solution that is suitable for the client’s needs.  When managed funds are part of that solution the adviser must understand the thinking and process of the fund manager.  The adviser must take responsibility for what is recommended – that duty cannot be outsourced.

A second reason for understanding funds is that it helps advisers build a deeper client relationship.  A client is likely to place greater trust in an adviser who can demonstrate a deep understanding of product solutions.  You cannot be an expert if you don’t know how the fund works. 

Manager businesses - “infrastructure” and “investment”

At a high level fund manager businesses can be thought of having 2 components – “infrastructure” and “investment”.  This month we look at manager infrastructure and next month we will tackle investment.  Manager infrastructure can be broken down into a further 4 categories:

  • People
  • Process
  • Price
  • Published information

We deal with each below.

1.  People

It is critical for advisers to know who is behind a fund management business – the owners, directors and senior managers.  Their values, culture and investment philosophy will be reflected right through the business including in the way they structure funds, charge fees and manage conflicts of interest. 

Investors want an allignment of interest with the people that manage their money.  Often this is intended to come through performance fees.  But it is not the manager’s business (i.e. the corporate entity) that investors need to align with – it is the individuals who manage the fund (i.e. staff).  Do performance fee payments to the corporate entity flow through to the staff or is it distributed as dividends to shareholders?  If staff KPIs and remuneration have different metrics to the performance fee calulcation, then what alignment do you really have?

A further focus of people behind a fund is to question whether key portfolio managers invest in the fund they manage.  Morningstar research out of the US found successful funds had an average of seven times as much investment from the portfolio manager as unsuccessful funds.  They described it as “staggering” how many mangers did not invest in their funds, and concluded that investors should not invest in a fund if the portfolio manager doesn’t.  Yet virtually noone asks about the portfolio manager’s personal investment in New Zealand.

Questions to ask about people:

  • Who owns the manager business?
  • How would you describe the group culture?
  • Are there any conflicts of interest within the group?
  • What are the KPIs of key fund manager staff?  How are they remunerated?
  • How much does each portfolio manager have invested in the fund?

2. Process

By “process” we mean compliance and governance process, not investment process (which we will discuss next month).  In a manager’s business both governance and compliance are critical to mitigating structural risks and conflicts of interest.  A compliance oriented culture promotes investor interests – an excessive focus on risk taking can undermine those interests.

Managers cannot be specialists in everything.  They are hired for investment management skills – they must justify undertaking other tasks.  Fund managers are (generally) not specialists at operating unit registers or fund accounting.  They should never act as a custodian and hold fund assets – there should always be a separate and independent custodian.  Advisers need to understand what tasks are not outsourced (and why).

Each business, no matter how large, will have strengths (such as specialist investment skills) and also weaknesses (such as key man risk).  Advisers need to ask questions about process to draw out this information.

Questions to ask about process:

  • Describe the governance framework?  Who are the independent directors?
  • What compliance policies are there?
  • Who are key service providers? (registry, custodian, trustee, fund accounting, auditor etc)
  • What functions are not outsourced?  (and why?)
  • What are the key strengths and weaknesses of the business?

3. Price

According to Warren Buffett, “price is what you pay, value is what you get.”  Cheap is not always good – cost and value need to be weighed together.  Comparing cost between funds on a “like for like” basis can be tricky as it’s often hard to accurately measure manager fees.  An investor needs to quantify all costs charged within a fund (the MER) and then add all costs outside the fund such as charges in fund of fund structures (the TER).  Think about the MER and TER not just as numbers, but also in terms of how the components are calculated – is the fee structure constructed fairly?     

The next step is to think about the reasonableness of fees compared to peers.  If a manager’s TER is higher than comparable managers, is there a fair reason to justify this difference (such as they have higher research team costs or the lower fee peer is a purely passive manager)? 

Questions to ask about price:

  • What is the fund MER and TER?
  • What other costs are not included in the TER (such as brokerage or performance fees)?
  • How does the performance fee work?
  • Is there any reason why the manager should be paid more than its peers?

4. Published information

The way funds report should be standardised, but it is not - this makes life hard for investors.  Sometimes monthly disclosure only skims the surface, perhaps because of a reluctance to reveal proprietory information.  Sometimes the method of disclsoure can totally confuse the reader.  

What if a manager reported all returns from retail funds before (not after) fees?  That would be different to how everyone else reports – and different to all KiwiSaver reporting.  What if a manager compared their equity fund performance to a capital index (i.e. an index which excludes dividends) – that would be different to all other managers and unfair to investors.  Investors and advisers need to put the microscope on what a manager reports differently to other managers.

Questions to ask about published information:

  • Is any part of fund reporting done differently to peers?
  • What parts of the investment holdings or investment process is proprietory and not disclosed?

Why ask questions – can’t we just read the research…?

External research can help in the process of understanding managed funds – but it is not the sole answer.  Firstly it is not always available (in the last 12 months we have seen 4 major research houses either massively downsize or entirely exit NZ research).  Secondly external research can have limitations.  While qualitative (process) views are very valuable, the conclusions should be recognized as opinions not facts.  Pure quantitative research also has limitations.

To illustrate this let’s assume you want to select a global equity fund and a property securities fund.  Below is real performance data for 4 funds, which 2 would you select:

Sector 1 year return 2 year return 3 year return 5 year return Volatility
Global equities A 25.3% 17.2% 13.8% ---- 8.9%
Global equities B 14.8% 9.8% 11.7% ---- 5.8%
Property securities A 26.9% 17.8% 19.3% 16.3% 13.5%
Property securities B 17.3% 15.8% 15.4% 9.3% 5.1%

Do you invest in growth assets for higher return even if a little more volatile (in which case you might select global equity fund A and property securities fund A)?  Or when investing in growth assets do you want to sacrifice return and minimise volatility (in which case you could select global equity fund B and property securities fund B)?  Perhaps you seek a more nuanced solution – may be you don’t care about upside volatility and realise that the downside volatility of global equity fund A is actually 4.2% (which is less than broader market volatility). 

If you relied on one research house their methodology selects global equity fund B (four stars) over global equity fund A (two stars).  And they would select property securities fund B (five stars) over property securities fund A (one star).  Yes, massive outperformance over every time period by property securities fund A and it is rewarded with one star!  The research house methodology rewards low volatility more than outperformance.  It is not a question of right or wrong – the methodology provides an opinion and so has limitations.   Every adviser needs to read research but also think independently.  Form your own view. 

Good news for advisers

Help is on its way for advisers.  The Financial Markets Conduct Act requires fund managers to be licensed by December 2016.  Part of the licensing process involves the FMA looking in intimate detail at manager compliance, governance and risk management.  This helps with “process” above.  After licensing a new disclosure and offer document regime must be adopted by managers – this will help with comparablity of “price” and “published information” above.  While information will be more accessible, advisers will still review it and take responsibility for providing the client solution.

We have covered fund manager infrastructure this month – people, process, price and published information. Next month we look at four more “Ps” to cover the investment side of manager businesses – philosophy, product, portfolio and performance.

Tags: Pathfinder Asset Management

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