The hardest part of active management

In my past professional life I led research and analysis for a $600 million Colorado-based Registered Investment Advisor. I was primarily responsible for the ongoing due diligence and research of actively-managed mutual funds and separately managed accounts for recommendation to our clients. I reviewed performance statistics, trailing returns, performance attribution, manager biographies and tenure, fund company structure and peer group and benchmark comparisons.

Finding a manager that has performed well in the past isn’t too difficult.

Finding a manager with some performance consistency is a little bit harder.

Finding a manager with performance consistency, long tenure at the fund, low turnover and reasonable fees narrows the field more.

Tack on a good corporate structure, manager’s own money in the fund and a consistent investment strategy and you’ll have a very short list in whatever category you’re looking in.

Add in some qualitative research (on-site or conference call with fund representation) and make your decision.

Congratulations, you’re the proud owner of an actively managed portfolio. Now all you have to do is monitor the manager.  Easy, right?

You’ll compare performance to peers, to the benchmark, taking into account risk-adjusted returns and the current market environment. You’ll watch trailing/rolling alpha for performance degradation. You’ll keep an eye out for personnel changes.

And then, one day, your manager will start to underperform.  The strategy will be out of favor, or there will be a misstep.  “No big deal,” you’ll say. “All managers go through a period of underperformance,” you’ll say.  “I’m going to be patient and give them the benefit of the doubt.”

Sometimes the manager will bounce back after six or 12 months. Other times s/he won’t. If not, some time after an extended period of relative underperformance, you’re faced with a decision.

What do you do with this manager? Keep or fire?  This is the hardest part.

If you’re a professional, you’ve told your clients that you did all of the necessary research and due diligence on this manager.  You separated this manager out from the chaff, the riffraff of the investment world.  You had a high degree of confidence that s/he would deliver. And now there’s no delivery on this promise, there is regret.  Let me draw a (hypothetical) picture.

You hired Jonny Gogetter’s “All-Alpha-Always” large-cap stock fund (AAA Fund) in to replace another manager that had underperformed.  Most of the positions for your clients were in taxable account, with an average position of $50,000. The fund gained but failed to keep pace with the S&P 500.  Cumulatively the market is up 45%, but Johnny’s fund is only up 33%, trailing the benchmark by roughly 3-4% per year over a few years. Your client’s average position would be $72,500 if AAA Fund had kept pace with its benchmark, but instead is only $66,500.

If you fire Johnny’s fund, your clients in taxable accounts will take a long-term capital gain of $16,500 and pay (15%) taxes of $2,475, leaving them with $64,025. A new manager you hire to replace Johnny’s AAA fund will have to not only make up the $2,475 paid in taxes, but hopefully also close the $5,500 gap created by Johhny’s underperformance.

If you keep the AAA fund, you have to hope that Johnny’s stretch of underperformance will turn around and he will catch up with the benchmark.

The difficult reality is this:

You have no idea what is going to happen, because you cannot predict the future.

But you made your bed, you promised yourself and/or clients that you could identify future performance stars.  So you have to choose.

Or you could have originally invested in an index fund for 0.10% or less, had an investment that you could hold practically forever, that will never disappoint you, (probably) never distribute a capital gain, that provides a wonderfully simple, cheap and tax-efficient investment so that you may now focus on things you can actually control.

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