In Real Estate, it’s location, location, location. In investing, it’s philosophy, process, and people. Most investors look at past performance when evaluating a manager. That’s a rearview mirror approach. If you’re driving forward, keeping your eyes on the rearview mirror is dangerous. Looking backward is equally dangerous for investors. You can’t buy past performance, so don’t invest based just on looking backward. To avoid that mistake, here’s a simple process that works for any investment manager you might hire—mutual funds, separate accounts, or alternatives.
When you are evaluating money managers, find out what their investment philosophy is. What is their unique view of the investment world? How is it different from those of their competitors? Is it credible that a manager can overcome the drag of expenses and taxes and provide risk-adjusted returns better than other alternatives? Basically, you’re looking for a good and credible story. How might you find it? Read the manager’s letters, prospectus and marketing material; look for something more than “we buy low and sell high.”
A good story is nice, but how does the manager make it work in the real world? Answers to this question may be harder to pin down, but remember, it’s your hard-earned money at risk.
Philosophy and process are essential, but ultimately it’s people who make the difference. People will be making investment decisions about your money.
Don Phillips is a managing director and board member of Morningstar. He is a good friend of mine and one of the most-respected professionals in finance. He has some simple advice regarding people: “You want people with passion for the job of money manager.”
Did the managers you are considering invent the firm’s philosophy and process or have they at least been around long enough to have developed a passion for it? If not, even if the investment passes the test of the first two Ps, move on to your next investment alternative.
Testing the Ps
In this conversation with a gentleman I will call Happy Promoter, I put the three Ps to the test.
Happy Promoter (HP): Good morning, Mr. Evensky. My name is Happy Promoter. I’m familiar with your firm and I appreciate your taking the time to see me this morning.
Harold Evensky (HE): Mr. Promoter, it’s my pleasure. I understand you represent Sophisticated Hedge Fund Strategies and you have a new offering available. My friend Mr. Jones suggested I meet with you; I’m always interested in learning about new potential investments for our clients. Please tell me about your program.
HP: It’s a very sophisticated long-short strategy based on an evaluation of a myriad of market dynamics that guide our trading algorithms to ensure that we provide consistent alpha in all markets. Because we can profit in both rising and falling markets, we can mitigate downside risk, and by the judicious use of margin, we can provide returns that significantly exceed the S&P 500. We’ve backtested our strategy for the last ten years and the results substantiate the success of our strategy.
Well, at this point, I’m thinking I need to know a lot more before I take Mr. Promoter’s pitch seriously. Backtesting is a common but questionable way of evaluating a new investment strategy. It mathematically simulates how the strategy would have fared if it had existed in the past. One obvious problem is that unless the strategy is 100 percent automatic—no active decisions or modifications are made by the manager along the way—there is no way of knowing if the simulation is a fair representation of how the strategy will be implemented in the future. An even bigger problem is that there’s no reason to believe that future markets will mirror the historical environment used for the backtesting. Bottom line: because it theoretically would have worked in the past is no reason to believe it will succeed in the future. The financial world is full of failed investment strategies that had wonderful backtest results.
So, I decide I need to take Mr. Promoter through the process I call the “three Ps.”
HE: Mr. Promoter, what you’ve said sounds good, but I need more meat to the story. Can you tell me what your basic investment philosophy is? What do you see in the financial markets that the thousands of other professional investment managers don’t? After all, the market is a zero-sum game. For everyone who makes a buck, there has to be someone else losing one.
HP: Harold—may I call you Harold?
HP: We believe that our sophisticated algorithms will provide the edge.
HE: I understand that, but can you be more specific?
HP: No, I’m afraid that our process is quite confidential and proprietary.
HE: Well then, can you at least give me some details about the procedures you use to implement your sophisticated process?
HP: Good lord, no! Our system is a black box and all the details are carefully guarded secrets. It’s the “secret sauce” that enables us to provide the low-volatility, high returns your clients are seeking.
HE: I see. Then I guess I’d have to look to the experience and quality of the intellectual capital behind your strategy. Will you tell me who developed your sophisticated strategy and what experience they have in implementing it?
HP: Harold, I’m the lead creator of the strategy and I’m supported by a two-man team of MBAs. My educational background is a master’s in History; however, I’ve been fascinated by the market for decades and I spent the last few years studying market movements. I finished developing my strategy just last month. I know that as a sophisticated practitioner you’re aware that alternative managers with well-established track records work only with large institutional clients and have no interest in dealing in the retail market, so a new manager such as I can provide your clients with the best alternative.
Mr. Promoter seemed like a nice guy, but he miserably failed the three Ps, so I thanked him for his time. My only thought after this brief meeting was, “What a waste of time; wait until I get hold of Jones!”
This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.