They Shoot Horses, Don’t They? By: Gabriel PotterMBA, AIFA® 2015.05.27

We are enjoying the middle of reporting season wherein we talk with clients and review their results for the previous quarter.  As always, our clients look over the various performance measures and notice that not every manager is beating their benchmarks in the short term.  Naturally, some wonder if all of their investment managers are worth keeping?  
 
It’s a reasonable question.  Clients pay investment managers to outperform their benchmarks and they don’t always do it.  Why should we keep paying them? 
 
The best investment managers in the world – the undisputed best of the best – have batting averages of 55%.  What’s a batting average, you ask?  A batting average is an investment manager’s historical record of beating their benchmark.  So, if you have a large cap core fund with a quarterly batting average of 60%, that means the manager has a 60% chance of having returns better than the S&P 500 any given quarter.  Through the magic of compounding, a 55% batting average should yield tremendous cumulative excess returns over a long term time horizon.  However, a 55% batting average ALSO means that managers will still have to explain their underperformance relative to the benchmark about half of the time.  Another way to look at it:  if you have a portfolio of a dozen separate investment managers, even the very best, you can still count on about half of them underperforming their benchmark for any given quarter.   
 
Identifying the criteria for placing an investment manager on a watch list – or replacing them – is an important part of a fiduciary process.  Consistent, unexpected underperformance is a cause for concern and may be worth firing a manager over.  Further, there are qualitative issues (i.e. change of management team, change of mandate, increasing fees, analyst downgrades, and so on) which can warrant a replacement of your investment lineup.  In short, the question on whether or not to fire an investment manager often comes down to longer term issues, but there are short-term red-flags that merit an immediate firing.  Just be sure you’re doing it for the right reasons.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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