We believe that identifying truly skilled managers who will beat their benchmarks is highly labor intensive and requires a great deal of skill, experience and judgment. We further acknowledge that the average active manager will underperform his or her benchmark as a result of expenses and transaction costs. However, using active managers does not require that we use all active managers, or that we use the average active manager. We only have to be able to identify a small number of skilled managers in order to add value. We can set a very high bar where if we can’t identify a manager in whom we have high confidence in their ability to outperform a benchmark going forward, we can instead use an index or index alternative. The due diligence approach we employ in selecting managers is based on this very high hurdle. We are seeking to identify not only skill, but also whether there are areas of uncertainty that have the potential to erode our confidence. Our goal is to own only those managers where our confidence is very high and the uncertainties are very low.
Our fund research process begins with performance screens to identify funds that may be worthy of further research. By itself, past performance has no predictive value, and therefore significant additional work is required to identify managers likely to outperform in the future. Our process involves identifying why a fund performed well in the past, determining if the portfolio management team has an identifiable edge that contributed to that outperformance (i.e., are we confident the past performance was the result of skill rather than luck) and assessing whether the edge (if one exists) is sustainable. To answer these questions requires intensive firsthand contact with fund managers and their research teams. The following article outlines our six-step process of selecting mutual fund managers.
Step One: Performance Screens. Performance screens and quantitative analysis are a starting point in our research process. We consider funds that have outperformed their peer group and benchmarks over a reasonably long period of time (generally five years or more). Occasionally we will consider funds with a shorter record. We have created our own proprietary database of manager returns that enables us to incorporate separate account and mutual fund track records, and we are willing to take those into account if we believe they are representative of how the existing fund would have performed over the same time period. In addition to absolute performance we take into account:
- Performance consistency, volatility and downside risk relative to the fund’s peer group and benchmarks over a wide variety of time periods (which we can adjust in our database)
- Special factors that impacted performance that may not be repeatable, such as a very large contribution to longer-term outperformance from a single year or from just one or two “home run” stocks
- The level of assets on which the record was based, as it’s a possible red flag if assets are now much larger and the performance was generated with a tiny asset base and/or by investing in small companies
- Our expense limits of 1.2% for larger-cap funds and 1.5% for international and smaller-cap funds. However, we will make an exception for a new fund with a small asset base if the expense ratio will fall below our limit as assets increase.
Step Two: Due Diligence Questionnaire and Document Review. If a fund passes our performance screens and looks promising on a quantitative basis, the next step is for the fund management firm to complete our detailed due diligence questionnaire. Their answers will start to build our understanding of their investment approach and management practices. Our questions delve into the firm’s investment philosophy and process, portfolio management and risk control policies, team members and roles, their compensation practices and incentives, and growth plans. We also read all of the fund’s shareholder reports and manager commentaries going back a number of years, as well as any media articles and interviews that may give us additional insights into their thinking and decision making process.
Step Three: Initial Portfolio Manager Interview. After reviewing the responses to our questionnaire we formulate more detailed follow-up questions, and conduct a phone interview with the portfolio manager(s). This is an important part of the process in which we begin to qualitatively assess the manager’s discipline and skill. We ask for specific examples as we attempt to verify that the manager’s actual practices are in line with how the investment process is articulated in the questionnaire and other documents, and to understand aspects of his/her approach that may not come through clearly from the questionnaire. We want to understand the reasoning behind the manager’s investment philosophy and process, how it has evolved, their degree of intellectual honesty and willingness to admit mistakes, how hard they work, what they expect from their team, and how competitive and driven they are. We also conduct phone calls with members of the analyst team to assess their quality and contribution to the process.
Often, after this initial phone contact, we eliminate the manager from further consideration despite their strong historical performance, due to qualitative red flags. For example, we may find the manager to be an “empire-builder” who is more focused on growing the firm than on the stock picking work that earned his/her growth in the first place. Such individuals can be overconfident, with a tendency to rationalize excessive asset growth, or can spread themselves too thin with non-stock-picking responsibilities. Or we may not be able to get comfortable with the manager’s philosophy or research process, and be unable to see clearly how the past success can be repeated and sustained. We don’t pretend to have all the answers, and a great manager may have a process that we can’t fully get our hands around. We know we won’t be able to identify every great manager, but we also know that is not a requirement for us to succeed.
If after the initial interviews we have built a strong confidence in the manager’s investment process, discipline in executing that process, and plans for managing growth, we will normally schedule a visit to their offices for on-site due diligence.
Step Four: The Site Visit. Our objectives of the site visit are to spend time face-to-face with the manager(s) and also visit with the analyst team and other key investment team members, e.g., traders. We will try to assess the following in more detail:
- Determine if there is consistency between the way the manager describes his/her investment process and the stocks they actually own. We want to know if the way that each stock was researched and the justification for the buy decision are in line with the investment philosophy, so we grill the manager about stocks in the portfolio. We do the same thing to assess their sell discipline, discussing stocks that have been sold and the reasons why. If we find major inconsistencies this might tell us that the manager is not disciplined in executing the strategy or that the description of their investment process includes aspects that are more marketing spin than substance. Either one is a big negative.
- Determine if there is consistency among all team members. By talking to members of the analyst team, we can see if everyone is on the same page and gain further clues as to whether the process is executed as described.
- Evaluate the quality of the team. We evaluate how smart, driven, focused, passionate, experienced, humble, confident, performance-oriented, etc., the analysts are.
- Evaluate the culture and compensation incentive systems. We want to assess whether the team is likely to stick together. We believe stability is critical to the ability of an investment organization to stay focused, so we look for firms that have healthy work environments and where everyone is passionate about what they are doing. If there has been personnel turnover in the past, we do everything we can to understand the reasons behind it.
- Understand management’s vision for their business. We want to know how they see the firm changing over time, how the team might change, what other products they might launch, how big they want to get, etc. We understand that all businesses want to grow, but we want to see the desire for growth balanced against a clear understanding of the firm’s fiduciary responsibility to its current shareholders.
Step Five: Final Follow-up and Third-Party Contacts. After we digest the information acquired during the site visit, there are usually some additional questions that require follow-up by phone or email. If there are further questions or issues that can’t be resolved from talking to the manager, we will use our extensive industry contacts to do more detective work. Sometimes we know people in the industry who worked with key members of the team at another job or who previously worked at the firm we are researching. At times these contacts are invaluable. We also check firm references (e.g., clients, Wall Street brokers) in situations when we think it will add value.
Step Six: Litman Gregory Research Team Vetting. Finally, the lead analyst responsible for covering the fund presents his analysis and opinion at a Litman Gregory research team meeting. (We should note that the team has many informal conversations and meetings discussing the funds we are working on prior to the more formal final meeting). If the analyst thinks the fund is worthy of recommendation, which signifies confidence that it will beat a benchmark going forward, he or she must convince the rest of the team. We have lively discussions and debates, with other members of the team playing the role of devil’s advocate, challenging the lead analyst to support or expand on certain points. This meeting typically lasts several hours, and in many cases it generates a few additional questions/issues for the analyst to follow up on before a final decision is made. The research team meeting is an important final step in our investment discipline. The analyst knows he/she will have to present their case before the entire research team and that people will be on the lookout for any analytical errors, biases or shortcuts in research. Consequently, it is important to be very thorough in the research and analysis prior to the meeting.
Ongoing Monitoring: If a fund makes it onto our Recommended List we continue to monitor it closely, and we will continue to do so for as long as the fund remains recommended. The most important aspect of our monitoring process is a regularly scheduled “fund update” phone interview with the fund’s manager. In these calls we cover significant developments and changes in the portfolio, the team, the firm, etc., and we continue to test our original thesis for recommending the manager. We have in-depth discussions of stocks they have recently bought and/or sold in order to assess whether or not they are sticking to their investment discipline. We also use these interviews as an opportunity to gain further insight into their asset class. Our typical fund update cycle is every six to eight months and the phone interviews typically last 60 to 90 minutes. However, any time there is a significant event, such as the departure of a team member or the addition of a co-portfolio manager, we will contact the manager immediately to follow up. In addition, when fund managers and analysts are in the San Francisco Bay Area they often come by our offices to meet with the research team. What are we looking for in this time-consuming and labor-intensive process? Simply stated, we are looking for managers with an identifiable edge that we are highly confident can be maintained.
Click HERE for examples of what makes a good stock picker.
The Importance of our Discipline
Just as we demand a clear investment discipline in the managers we recommend, it’s vital that we maintain our own discipline and very high standards. Going through all these steps doesn’t guarantee success. Critically important to preventing mistakes is our acceptance that not many managers will make the cut. This doesn’t bother us because we don’t need to identify very many great managers. We only need a few. And the reality is there are not that many highly skilled stock pickers out there that have an identifiable edge who we believe will also maintain their focus, team stability and grow their business with shareholders in mind (as opposed to maximizing their own bottom line). So though it is frustrating to spend 30 to 60 hours (or more) investigating a fund company only to decide that they don’t make the cut, maintaining a very high standard reduces mistakes. So we pass on fund companies if we don’t get all the information we need, if our conviction level is not extremely high, if we are not sure if the firm is being straightforward or if we have significant doubts about any of the above keys to success.
The benefits of all this work go beyond significantly increasing our batting average when it comes to fund/manager selection. In addition, it allows us to be patient with managers who go through a slump, as they all do eventually. If one our recommended funds starts underperforming, we circle back, try to understand what is going on and assess if something significant has changed with the team or process or if we missed something in our initial analysis. If none of the reasons for initially recommending the fund have changed, then we have the confidence (based on our exhaustive upfront research) to stick with a manager who is underperforming for a while, or whose style of investing is temporarily out of favor.
Investors want quick answers. Some quick answers are arrived at by projecting a track record forward without any additional thought. For those who realize the flaws in this approach, buying the whole market at the lowest possible cost (indexing) provides another quick answer. Doing high quality due diligence on stock pickers and fund companies requires a disciplined, exhaustively thorough effort—it is not a quick answer. It is highly labor intensive. But we believe that in doing the hard work that no one else wants to do, we can continue to add value by finding managers who will be able to beat market benchmarks over the long term. And as is true throughout investing, a small edge adds up to big rewards over time.