In our Investment Strategy Note we discuss key sell signals for fund managers and what we do to avoid those risks.
Most investors are focused on selecting fund managers. But there is less focus on when to actually sell a fund that is no longer delivering on your investment objectives.
When an investor considers selling a manager, they need to analyse a range of issues, some quantitative some qualitative. The analysis extends far beyond merely studying past returns.
In this note we highlight seven ‘flags’ that could lead investors to terminate their relationship with a fund manager. The seven flags provide a framework for investors to make an informed decision on selling. It will help them avoid the steep costs of having capital tied up with a fund manager that is no longer right for them.
Of course, prevention is best. We will also list the steps we take at Ophir to safeguard against the seven risks, so investors will hopefully never have to decide to sell our own funds.
- Poor performance
The most obvious reason to fire a fund manager is disappointing investment returns. While performance monitoring is important, it should only be done periodically and must be consistent with your original investment goals. When a fund manager underperforms, it must be examined in proper context to determine whether the problems are correctable and when acceptable performance is likely to resume.
Even during longer-term trends, financial markets move in cycles. Small cap equities, for example, have generally outpaced large caps over time, but there are always short or medium-term periods where the opposite occurs.
Investors should be disciplined and avoid becoming overly influenced by recent performance, which could lead to making bad choices. We avoid such mistakes by emphasising patience and discipline as the cornerstones of our long-term wealth creation plan. A vast majority of long term (10+ years) top performing equity fund managers regularly have shorter periods (1-3 years) of underperformance, and sometimes quite significantly. History is clear, selling a fund manager solely based on short term underperformance is a recipe for disaster for investors. Shorter term underperformance is generally a trait, not a bug, of long-term top performing fund managers.
- Not following process
Before they allocate money to a fund, investors should educate themselves on the manager’s investment philosophy and processes. Ideally this would encompass rules relating to sector, industry, market cap, and style. By understanding these steps, the investor can judge if the fund manager’s risk profile fits with their own.
In certain instances, you may decide that you do not want managers held too tightly to those self-imposed disciplines. But letting them drift too far, or for too long from their processes, is likely to create more problems as this may not be where their core capability and experience lies. It follows that when a manager violates their own policies, it creates grounds for firing.
- Changing their style
Relatedly, each investment manager is likely to have its own definition of where its style falls within the various dimensions of value versus growth versus core. A manager should also distinguish their process between a ‘fundamental’ process — one relying on in-depth financial analysis and qualitative evaluation of management teams — versus a ‘quantitative’ process, which objectively analyses companies using data and computer models.
There is no right or wrong investing style to pursue. The one that ultimately works best for you depends in large part on your risk tolerance, time horizon for investing, and investment goals. As you grow older your preferred investment style is likely to shift as your own investment objectives evolve.
But these changes should be made by you, not your manager. If a manager starts investing in a way inconsistent with the style you understood when first investing, it is time to look for a new manager who will. Much like when a successful career baseline tennis player starts playing more and more from the net – you may have reason to suspect a less successful outcome!
- Breaching capacity
Another flag is when fund managers begin to manage too much money and it begins to hurt performance.
Any active equity strategy will have its own limit. As funds under management grow, the manager’s ability to outperform slowly erodes. This limit, or ‘capacity’, is the maximum amount of money a strategy can still expect to achieve its performance targets.
When a fund breaches capacity levels it suggests the investment manager has turned into an ‘asset gatherer’ rather than a ‘maximiser’ of future investment returns. This is a clear prompt for investors to exit and seek a new fund.
Capacity is particularly relevant in the smaller and less liquid corners of the equity market. For this reason we closed both the Ophir High Conviction Fund and the Ophir Opportunities Fund to all additional investments. We decided to close the funds to ensure that the underlying investment strategy can continue to take full advantage of attractive investment opportunities.
- Misaligning incentives
A fund manager should strive to align the interest of its investors with its owners and portfolio managers. If they don’t, the interests of the firm and its staff can be prioritised over its investors.
An example of this is where fund managers are allowed to trade individual shares on “personal account”. Here if a manager owns the same shares in the managed fund and also personally, they have a conflict about which shares they should trade first when they change their mind on a stock – those of the fund, which can often be mostly “other people’s money”, or in their own personal account. A sticky situation where investors interests many not be prioritised first.
Alignment is one of Ophir’s core values. We have always invested our own capital alongside our investors to ensure alignment. We have a remuneration structure where portfolio managers’ pay is largely dictated by, and commensurate with, the long-term investment returns the fund has delivered to investors. No trading on “personal account” is also permitted at Ophir.
- Culture clash
The DNA of a good fund manager lies in its culture. Having clever and experienced analysts is great, but without the right work culture, the performance of the fund is never likely to reach its full potential.
It is no accident we constantly hear stories of unethical behaviour in the financial services. They are almost always a product of a weak culture that facilitates excessive risk taking and downplays compliance. Firms that operate in this manner should not be managing your money. As Warren Buffett has said “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently”.
At Ophir our reputation is everything, so we take every step to ensure that we maintain a culture which builds trust and delivers long-term performance to investors.
- Team turnover
Over the years, we have seen funds with a track record of consistently good performance languish after a fund manager leaves the firm. Irrespective whether they are retiring, or jumping ship, a star fund manager’s exit poses important questions to investors such as how much of their performance was due to their unique skill (which may not be replicable), and how much is due to the firm investment philosophy and process (which may be)? : …
To protect ourselves against this risk, we ensure our business is a product of, not any one person, but a team of portfolio managers, each of whom have ownership in the firm. And sitting above the team is a systemised and established investment process, including robust company research.
Like selling a stock
Firing a manager can be a complex exercise. There is a lot to consider and the information needed is not always easily available. When an investor replaces a manager it can be costly because it requires finding a new fund, and then hoping it performs.
But when making that decision, just as a portfolio manager has a process to guide decisions on selling stocks, investors should have a process or framework to guide their decision to let go of their fund manager.
Ultimately, however, the best way to avoid having to fire a fund manager is by investing in one that never gives you a reason to. That is our aim at Ophir.