Skill vs Luck in Money Manager Choice. How Can You Decide?

we discussed some of the research that shows that while money management skill does exist, it is extremely rare and there are no criteria for identifying individuals who are skillful. We then touched a few ideas for you to apply when choosing a money manager.

We’ll be more comprehensive and specific in this post. We’ll follow and elaborate on the points raised today in an article in the Wall St. Journal:

Seven Questions to Ask When Picking a Financial Adviser

by Shelly Banjo

13 APRIL 2009

http://online.wsj.com/article/SB123913983139498483.html

The key assumption is that the client doesn’t have the time or expertise to manage his own investments and seeks a professional advisor to help.

In the end, it all boils down to having wise conversations for action.

1. What’s in the advisor’s background?

Investors should know the difference between advisors who have a fiduciary duty to their clients, and those, like stock brokers, who do not. Registered investment advisors have a fiduciary duty to make their highest priority their client’s best interest, even over the advisor’s own interests.

Registered investment advisors (such as your humble servant) must pass a test (Series 65 Uniform Investment Advisor Law Examination) or have certain forms of certification, such as being a Certified Financial Planner (CFP), as a necessary qualification to legally be an advisor.

A registered investment advisor must also disclose a substantial amount of detail about his business such as any formal investigations and disciplinary actions initiated by regulators, along with any customer disputes, certain criminal charges and financial disclosures, including bankruptcies, and education, address and fee structure. These disclosures (form ADV part 2) are found online at

http://www.adviserinfo.sec.gov/IAPD/Content/Search/iapd_OrgSearch.aspx

2. What do the advisor’s clients say?

Ask for references from the candidate advisor, and try to get references not initially named by the candidate. References can give you lots of information about how the advisor actually operates.

By the way, registered investment advisors are legally forbidden from soliciting or using testimonials themselves in advertising, but of course, references are free to volunteer anything they choose.

3. How does the advisor get paid?

Advisors get paid according to what they do for you. The main issues in compensation these days are to use structures that avoid conflicts of interest (such as sales commissions on financial products) and which also reward performance. Stock brokers, whose job includes selling financial products, are often thus conflicted and should tell you so. Registered investment advisors are usually not conflicted (if they don’t sell financial products) , but they must disclose any conflicts and commissions if such exist.

Advisors are forbidden to charge a fraction of profit to any client. While paying your advisor proportionally to his profit generated seems like a good idea to align advisor interests with your own, the SEC believes such an incentive structure would entice advisors to take excessive risk to achieve high profit (even though such high risk could possibly cause losses for both advisor and client).

The usual solution is for advisors to charge a small fraction of the assets under management each quarter. Fees will rise and fall with the asset base.

4. Where are the advisor’s checks and balances?

The client should get a written description of how the candidate advisor would choose a third party money manager in any situation for which the advisor himself wouldn’t be managing the money himself.

5. What’s the advisor’s track record?

We showed how uninformative track record can be. However, clients should demand a formal description of the process by which the advisor makes investment decisions (selecting, entering, holding and closing positons). Most registered investment advisors describe this in an Investment Policy Statement (IPS). The IPS  also defines the universe of permissible asset classes. The advisor’s process must be formally constrained to support the client’s risk profile (obtained from  extensive interviews of client). Clients can use the IPS to decide if the advisor’s process suits the clients style and preferences.

6. Can the advisor put it in writing?

These days, it is fully expected that professional advisors will specify their services in a Client Contract along with their detailed fee structure for those services. This contract is a great document for client and advisor to formally define their relationship and make formal disclosures. In this context, the SEC requires the advisor to provide his Form ADV Part 2 directly to the client five days before the contract is signed.

7. What do other pros think?

Clients should get third party opinions on the advisor and his decisions from time to time.

Even if a manager has a history of high ROI, his next year could be awful. These days, almost every manager has a rather terrible performance record for 2008. So there are probably lots of very highly skilled managers who performed horribly due to the massive economic collapse. Similarly, a poor history could precede a great year, e.g., because of learning. So it’s natural to want to pick a manager on the presumed likelihood of good future performance. But is ROI track record a useful predictor of skill or future performance? No.

Investment skill is a property of human mind, and thus cannot be specified or observed independently of its behavioral results, in this case, ROI. Thus, we must measure past investment performance and try to infer if some unobservable factor, called “skill” even exists. That still leaves open the question of how to detect skill in a particular manager.

One empirical approach to determine if skill exists takes a set of mutual funds with active managers (who rely on presumed skills) and compiles their performance over some time period. Through statistical  comparison with passively managed funds (non-skilled), researchers try to find explanations for the results that cannot be explained by “chance”, in which case the results are caused by an “X factor” loosely named “skill”.

Keep in mind that passive management requires the manager to track some reference benchmark.  Active management picks securities expected to have superior performance compared to the benchmark, but with no more risk.

The research results show that passive money management usually beats active, and that skill exists but is quite rare. (See the paper linked below, to review the details and subtleties of the research; emphasis added).

Luck_vs_skill_in_active_mutual_funds

The research still cannot predict who is the “most skillful” manager, and certainly cannot say which manager will have the best ROI next year.

An entirely new line of inquiry shows even persistent differences in ROI over time are not necessarily reliable indicators of differences in managers’ skills. Here’s the link (emphasis added):

Nickel-vs-black-swan-strategies

The differences may simply reflect differences in reputational concerns. Some managers may be so concerned to maintain their reputation they select an overly conservative strategy and perform worse than they otherwise could. Thus we now have two major factors, skill and reputational concern, that could account for a manager’s ROI results.

Obviously it’s hard to isolate the set of traits and reputational concerns sufficient to select a money manager. So, with all this difficulty isolating skilled managers, how can you choose?

First, ask yourself, and answer truthfully: Do I want to manage my own money? If yes, then do it. As your own manager, you will be picking securities and funds. You will necessarily decide for yourself  passive versus active.

If no, you must find another, even if you could do the job better yourself. This last point is really annoying, but it goes with the territory when you outsource. There are many things you pay others to do that you could do better yourself.

To select someone to manage your money, choose a manager who will wisely steward your money. Select based on your assessment that the manager will pay sufficient attention to your account and make your interests his highest concern. (The commitment to your interests is a fiduciary duty of Registered Investment Advisors, but not of stock brokers.)  He also should have the technical competence to handle various economic and market situations as they arise. In this context, “technical competence” is not the same as the delightful “investment skill” we all seek.

Technical competence can be observed, based on experience and education. Note than even passive management still requires portfolio adjustments from time to time, if for no other reason than to ensure meeting allocations or maintaining diversification. So the decision comes down to relationship building based on observable but subjective traits of commitment, competence and trust.