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Choosing the Best Mutual Fund

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In South African, Mutual Funds are known as "Collective Investment Schemes", which were previously known as "Unit Trusts".

Whilst using an online trading platform to buy/sell stocks on your own account has its place for some, most individuals at some point have a need to use some form of collective investment fund (for example, due to regulatory paternalism in South Africa, you're not allowed to choose retirement fund stocks yourself).

Investing is like playing poker

You gotta know when to hold 'em, know when to fold 'em

In choosing an active manager, it helps to imagine that you're at Montecasino watching a table of gamblers playing poker. There's some skill involved in poker, but also a lot of luck. The poker players have names like "Allan Gray", "Investec" and "RE:CM"; but there are also retail investors sitting at the table, foreign investors, the government pension fund and passive investors. Each hand played is equivalent to a stock trade, with somebody winnning, somebody losing, and Montecasino taking its cut of each hand is equivalent to trading costs.

dogs playing poker

The poker players are betting predominantly with other people's money, who want to be in on the gamble, even though they don't consider themselves skilled enough to do it on their own. Those other people pay the poker players to bet on their behalf, whether they win or lose (although some might pay them a bit less if they lose), and are hoping that the amount the poker players win will exceed the amount they're paying them.

Just like some people don't want to invest on the stock exchange themselves, they might not consider themselves good enough at poker to want to join the game, so they are looking at the players and trying to decide which of them you want to pay to play on their behalf. All the poker players are trying to convince them that they're the best at gambling, as they like to earn the fees they'll be paid. Even the player who's lost tons of money tells you that he's just had a run of bad luck, and he's actually very good at poker.

Why the poker analogy makes sense
Poker
Active investment management

What one man wins another man has lost

When you buy a share, another person must have sold it.
If the share outperforms your gain is the other person's loss.

Relative skill counts in poker, you're more likely to win if you're more skilfull than the other players.

Relative skill counts, in markets where the price isn't obvious it counts more than, for instance with money market investments.

Luck counts, even the worst poker players have winning streaks.

Over a period of a year, luck plays a far bigger role than skill.

Casino takes its cut on each hand.

With each trade brokers, the exchange and government (tax) take their share.

A stricter definition to take care of market rises

Now I know somebody is going to write to tell me that investing isn't a zero-sum, as when the markets rise all ships rise with it. That is why I specifically referred to "active management", as opposed to passive management. You see there are 2 strategies to investment:

The reward for active management over passive management is the return the manager achieves above his benchmark. Investment industry geeks call the return of the benchmark "Beta", and the return active managers achieve in excess of the benchmark "alpha" (active managers can also achieve negative alpha if they underperform their benchmark...this happen just over half the time). Stricly speaking I am drawing the analogy between paying an active manager to generate alpha and paying a poker player to play on your behalf at Grandwest.

Factors which may influence investment manager performance

Unless you go the passive route, one needs to maximise the chances that your chosen active manager is a better "poker player" than the others. If you're hiring a financial advisor to do this on your behalf, be certain to interrogate him on what factors he looks at in his manager research.

  • What are the initial fees, ongoing fees and exit fees charged?

  • How do you measure risk?

  • What rate do you pay your brokers for trading?

  • What criteria do you take into account in deciding which brokers to use?

  • Total expense ratio of the fund over the last 3 years?

  • Total portfolio turnover over the last 3 years (a long-term investment orientation will have lower turnover)

  • Inception date

  • What is the universe of assets you consider investing?

  • To what extent do you rely on external research in your decision-making process?

  • Which decisions are made by committee (and how many in the committee) and which are made by individuals? In committees is there one strong individual who makes the running after taking counsel?

  • Are you less likely to invest in any stocks, as you feel you cannot build up meaningful exposure to them?

  • Fund size under management in the particular area/s being looked at? Success is possibly more easily achieved by the medium-sized managers, which are resourced well enough to attract the best people with attractive salaries, but retain the flexibility to quickly take up significant positions in smaller stock, without overly moving the price.

  • What is your benchmark?

  • Do you consider the benchmark or tracking error to the benchmark anywhere in your investment process?

  • Do you try to predict where macroeconomic factors are moving?

  • To what extent is your investment process bottom-up vs top-down?

  • To what extent do you rely on macroeconomic vs business-specific vs industry-specific factors in your stock selection process?

  • Decision-makers and dates and changes of these since the inception of the fund. Lack of continuity of staff is both the symptom and cause of problems.

  • Investment experience of decision-makers (the first 10 years of experience are vital, thereafter there's diminishing returns)

  • To what extent are decision-makers invested alongside clients?

  • What are the month-on-month gross returns since the inception of your fund, and that of your benchmark? For a manager's skill (or lack thereof) to be statistically proven may require 12 years of returns, by which stage a lot will have changed at a business. I recognise that returns are not reliable indicators of manager skill, and I don't like judging managers over periods of less than 5 years (although I do like using it for timing purposes - in my opinion the best time to invest with a quality manager is when they've recently been underperforming). Just like the worst blackjack player will occassionally have a run of luck and win some money, even the worst asset manager will regularly see the cards turn in his favour. Investment returns exhibit a far higher ratio of noise to lucky than most investors believe. However, just like it's likely that a terrible blackjack player's lucky streak will come to an end sooner rather than later, it's likely that over a 5 year period your inferior fund managers strategies will start showing negative alpha. Exercise more caution if there have been large upward movements in the market over the 5 year period. A period of analysis requires both a downturn and an upturn. A good performance record provides a degree of comfort, without which I'd need a lot more conviction in other aspects of the analysis.

 

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