Investment Risk in Fund Manager Selection

Entrusting your capital to even the best-known and most prestigious of investment advisers can be a gamble.

Financial advisers often speak and write about the various kinds of risks that investors face – that markets may fall or the issuer of a security may go bankrupt. But I have never seen any of them refer to one of the biggest perils facing the individual investor – fund manager risk.

I’m sure most of us have had the experience that the moment we invest in a fund on the basis of the manager’s excellent record, the fund starts to underperform… or even nosedive.

There are many reasons for this:

► Outperformance often arises because a fund happens to be in the right place at the right time. It may be focused on Asia when things there are going particularly well, in blue chips when the weight of institutional money is pouring into large-cap stocks, or in a currently fashionable sector such as infotech. When fundamentals change or market sentiment turns, the fund loses its temporary advantage.

► This wouldn’t matter where the fund shifts its capital out of underperforming sectors or asset classes into those that have started to run. But this is rarely possible because of structural constraints. An Asian fund can’t switch its money to America, or an equity fund into bonds.

► There are also human constraints. Portfolio managers, for example, are prejudiced in favour of the kinds of investments with which they are familiar. A manager who is well-informed about tech stocks resists a switch to defensive stocks such as equity income when fundamentals change in favour of them.

► Another source of outperformance is the talent of an individual manager. But investment stars are readily poached by competitors or lured into hedge fund boutiques. When they leave, they are rarely replaced by people of equivalent talent. So the fund’s performance slips. Funds that have been top performers nearly always revert to being average, or worse, after a few years of delivering sizzling returns.

► Institutional managers are risk-averse, even risk-avoidance-obsessed, to avoid the criticism of clients, bosses, peers and now regulators whenever there are capital losses. Lower returns are an inevitable consequence.

► Fund managers work within corporate structures that reward conformity rather than minority views. Career-wise, it’s safer to go along with group-think that you’re uncomfortable with than to fight for your own minority, perhaps solitary, opinion. But consensus decisions usually deliver average returns.

► It’s much easier with your clients, colleagues and bosses to invest in shares that are currently rising, even though there’s much academic evidence that over longer time-spans it’s neglected stocks that are likely to outperform.

► Absence of a rigorous selling discipline. One reason is that it’s often difficult for a major fund holding a lot of a share to sell out without driving down the price against itself. Another is that fund managers have a bias towards optimism. It’s very important for them that markets should rise, which attracts investors’ capital and boosts the management company’s profits. So “the wish becomes father to the thought”. Buy recommendations have nearly always outnumbered sell recommendations by huge margins such as ten to one.

There are three ways to avoid fund manager risk:

Use index-tracking funds. They require no decisions about which shares to invest in or when to do so, so you are not exposed to the risk of manager misjudgements. A Vanguard study suggested that 93 per cent of the time you’ll do better in them than taking the chance on using active managers.

They’re much cheaper, too, as you’re not paying fat fees for underperformance. This cost-saving alone can make a significant difference to your eventual returns, especially now we have entered an era of single-digit returns.

Achieving guaranteed low-risk returns

Use a rebalancing plan. You allocate your capital according to a rigid formula – such as 25 per cent each in equities, bonds, property and gold. At the end of each year you rebalance your portfolio by selling and buying securities, or perhaps just redirecting the flow of new savings, to bring the proportions back to 25 per cent each.

This guarantees you modest but low-risk returns. You don’t have to make any investment decisions, with minimal hassle and low costs.

Do-it-yourself. Actively managing your own wealth is higher-risk, especially in the earlier years when you’re building up experience, but it should ultimately deliver bigger returns.

Although it’s true that, as an individual investor, you lack advantages of a professional manager such as access to corporate managements, analytical expertise and databases, you have some counterbalancing advantages:

► As it’s your money, you’ll remain intensely focused. You can monitor your affairs much more closely – on a daily basis if needs be. No professional manager can afford the time to do that for you with similar intensity.

► As you only deal in tiny volumes compared to fund managers, you are able quickly to jump into or out of markets, and invest in growing companies whose stock is too narrowly traded to interest financial institutions. You can make decisions based on factual analysis, without having to take into account company policy, peer group influences, or the views of sluggish, consensus-seeking committees.

► You save on the usually substantial overt and hidden charges you pay for someone else to manage your money. Of course, the price is many hours of your time. But for most of us who do it, that’s more a pleasure than a burden.