For much of my career I have been involved in researching and recommending active fund managers; this process typically involves extensive due diligence including numerous face to face meetings.  Whilst optically the types of interaction that take place in these meetings appear straightforward, the underlying dynamics are complex and have significant implications for the type of questions we might ask about a potential investment.

A major impediment to our ability to obtain useful information and insights in such situations is our, often overwhelming, desire to manage how we appear to others.  We are prone to ask questions (or fail to ask them) because of how it may reflect on us, rather than because of the importance of the question itself.   In a previous job, I was often accompanied to fund manager meetings by the CIO (my boss) and the firm’s own psychologist.  My line of questioning was undoubtedly influenced by concerns about how I was being perceived by colleagues and also whether I had gained the respect of the fund manager that we were interviewing.

In terms of the ultimate goal of the meetings these issues were, of course, an irrelevance.  Whilst striving to appear intelligent in front of others might be a rational action from a career development standpoint, it can lead to incomplete and ineffective questioning.  I think there are two particularly problematic behaviours:

1) Asking questions to prove our competence:

There is nothing wrong with asking detailed, specific questions – they are an essential part of a thorough research process – however, there needs to be a purpose and you actually should be interested in hearing the answer.  Impressing a fund manager with sophisticated questions does not mean that you are doing a good job of assessing their investment approach.

A major hurdle for fund manager research is that you are typically at an informational disadvantage – the individual or team you are researching knows more about the central topic than you (or they certainly should do).  Testing the depth of a manager’s knowledge can be important provided it is relevant to their investment approach, but you should always be able to justify why you are asking a particular question.  Don’t mistake a fund manager knowing the securities in which they invest for being a skilful investor.

2) Not asking questions to avoid appearing incompetent:

This is a more pernicious problem and can lead to significant investment mistakes – asking ‘simple’ or ‘dumb’ questions can be painful and bruising to your ego, it can feel as if you are making a claim to be the least informed person in the room.  Although it is often hard to combat (particularly if you are relatively junior) you should attempt to ignore such feelings for a variety of reasons:

– Simple questions can be the most difficult to answer, particularly where complicated investment products are concerned.  It is easy to become lost in the weeds of an investment strategy and forget core principles that can often be drawn out by unassuming questioning.  Seemingly naïve enquiries can be both challenging and insightful (as any parent will attest).

– Other people in the room are probably interested in the answer. You are unlikely to be alone in wanting responses to simple queries, but you might be the only person willing to raise them.  I have sat in numerous meetings during my career when a fund manager has used a technical term or a particular acronym which (on reflection) none of their interlocutors fully understood, yet nobody asked for clarification – presumably because we were each working on the assumption that we were the only ones in the room at a loss.

– Answering foundation questions is a solid discipline for any investor.  A useful heuristic for us all is that if the essence of an investment approach cannot be distilled into elementary concepts, it is probably best avoided.

– If you fail to ask simple questions, there are likely to be significant gaps in your understanding about any given investment.   Apart from the aforementioned perceived reputational issues, there is very little downside to this type of questioning – it doesn’t have to come at the expense of more detailed lines of enquiry.

It is important not to confuse a simplistic question with a bad one – asking an active fund manager about performance drivers over the last month is a simple question, but on almost all occasions a poor one.  Effective yet simple questions are those that improve your understanding of how and why a strategy works, and clarify areas of complexity or uncertainty.

Although I have used the context of meetings with active fund managers, the issue of self-presentation and how it impacts the type of questions we ask is crucial across many domains. Whilst expertise around complex areas is rightly highly regarded, it is usually the simple things that define our success or failure.  Take care to manage your investments rather than your image.

 

 

I have written previously about the central challenges of utilising active managers, namely:

• There are few skilful managers and they are difficult to identify. The odds of successful selection are often stacked against us.
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• There are major behavioural challenges to owning the type of active managers most likely to deliver excess returns – those running distinctive, conviction-driven, high active share strategies. Even if we are able to find them, we are unlikely to persist with them through difficult periods.

There is also a third major issue and it relates to timing. Trying to successfully time anything in investment markets is a fool’s errand, albeit a very common and alluring one. The same applies to investing in an active manager – it is impossible to predict with any level of confidence when a particular manager or style will generate strong returns. However, whilst we may not be able to gauge when an active strategy will deliver, it does not follow that we should ignore the issue of when to invest in such a fund.

For example, if we assume that the average skilful manager can generate 2% annualised excess returns over the long-term*, investing in a fund following a three year period where it has outperformed its benchmark by 5% annualised has material implications for the likely path of future returns and the probability of success for our own investment.  Such a scenario means that even when we have made a strong manager selection decision (i.e. we have found a talented individual); it can still result in us holding an underperforming strategy if performance reverts towards the mean.

This issue is created by the fact that excess returns are uneven – a skilful manager will not generate consistent outperformance each year (unless they are incredibly lucky); there will be periods of feast and famine.  Whilst an accomplished manager is likely to deliver positive long-term outcomes, we might not enjoy the benefit during our ownership period.

To invest in an active strategy subsequent to a period of outstanding results we need to assume not only that we have found a manager with skill, but a truly exceptional individual that can produce and sustain returns well beyond what we might typically expect, even if our reference class is only that rarefied group of skilful managers. When making such an investment decision it is crucial to be acutely aware of the assumptions being made and the base rates potentially being ignored.

I always find it troubling that we feel more comfortable investing in a fund that has very strong performance before we invest – this is other peoples’ alpha, returns that we will not be receiving when we buy the strategy**.  That we have not benefitted is a negative, not a positive.

The ideal scenario is to identify a manager that possesses skill and invest following a spell of weak performance, but this is a rare occurrence.  As we overweight the importance of outcomes and tend to greatly understate the role of randomness in financial markets; we associate poor relative returns from an active manager with a broken or flawed investment process.  Persuading clients and colleagues that investing in an underperforming fund is a prudent course of action can be a herculean task. The reputational risk is also great – buying a strongly outperforming fund that then deteriorates is acceptable and common, buying an underperforming fund that keeps getting worse is unconscionable.

Although we cannot forecast when an active strategy will work, the timing of an investment can materially alter the odds of success.  Even if we find a skilful manager, our propensity to buy after periods of abnormally strong performance can still lead to poor outcomes.

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* For long-term, let’s assume ten years. The average return of successful active managers will vary by asset class.

** Understanding how a manager has delivered outperformance and whether the positions / factors that are the most meaningful contributors to returns still feature in the portfolio is an important aspect of such analysis.