As I said last week, monitoring investment managers is a fairly large part of my job. As fiduciaries, we try to apply prudent, transparent and verifiable evaluation techniques to our method of investment manager due diligence.
We do not “go with our gut” or “act on a hunch”; we are bound by cold, hard facts as a primary component of investment manager research. In fact, most of our clients are used to seeing numeric scores for their investments, which reflect the quantifiable attributes of these investment products.
Before you think that the process is completely mechanical and automated, understand there is a lot of room for interpretation in these numbers. It is here that qualitative elements, which defy perfect numeric categorization, are key to our research. Furthermore, a thorough understanding to the strengths and weaknesses of quantitative investment selection methods is vital to form a fair opinion about an investment.
Let me give you an example:
Mutual fund ABC is a product which only buys corporate bonds with long durations. This product has a solid history of good risk adjusted performance relative to peers within their default category – Long-Duration bond managers. Their product scores well, is popular, and it is well-understood by their investors. In the meantime, a new peer group category is created for Corporate-Bond managers. As we said, fund ABC only buys corporate bonds and so the product gets moved into the newly created category. In other words, mutual fund ABC continued to operate normally; the only thing that changed was the peer group to which the product was being compared.
As a result of this re-categorization, the peer group changes from Long-Duration bond managers to Corporate-Bond managers, and quantitative scores suffer tremendously as a result. Why? First, mutual fund ABC is picking corporate bonds with long maturities, and – as you may know – they have suffered significantly more than short and medium duration bonds over the past year. Fund ABC’s chosen style is working counter to the currently favorable winds. Second, the “style-purity” score of fund ABC suffers. The funds in the new category, Corporate-Bonds, are of medium duration and fund ABC is clearly a long duration fund. Some quantitative scoring methodologies will penalize fund ABC for not adhering to the style of its peers. It is as if the fund’s approach has changed somehow when, in reality, the only thing that changed was the peer group.
In fairness, there is a perfectly reasonable argument for placing fund ABC in either the Long-Duration or Corporate-Bond category. An investment with multiple style attributes (in this case, both corporate credit bonds AND long duration) must be appreciated by the investor because fund ABC’s relative performance is a function of the peer group one compares the fund to. It simply is not accurate to assume that a fund is “good” or “bad” based on quantitative scores alone. Investors must recognize the relative strength and limitations of their managers beyond mechanically comparing numeric scores. Genuine understanding of investments comes with attention and due diligence.