Value investing, as pioneered by Benjamin Graham, is a strategy of buying stocks that are “undervalued” by the market – that is, selling for a price below their “intrinsic” (or true) value. Successful value investors profit by waiting to buy a quality stock only when its price is below its intrinsic value. As Graham said, stocks are subject to excessive price fluctuations and the time to buy is when the price is “unduly depressed by temporary adversity.”
But can this time-tested strategy also be applied in some fashion to the selection of investment managers and funds? If so, investors have opportunities to profit via the selection and retention of managers who significantly outperform over long periods of time. A comprehensive study by our firm found that managers whose 15-year returns from 1998-2013 were in the top quartile in their respective categories outperformed their benchmarks by an average of 4.5 percentage points per year – providing an average total benefit to clients of $935,000 for every $1 million invested.
Manager selection is a critical element of what we do at Altair. Our goal is to provide our clients with high-quality investment options that will outperform passive alternatives (indexes) over the long term, after all fees and taxes are deducted. We seek to achieve that goal by identifying and investing in exceptional money managers – ideally top-quartile performers like those discussed above. This approach has proven effective and very profitable over time. Choosing these managers is of course not as simple as calculating and ranking their long-term returns. We believe applying the principles of value investing can significantly aid the process.
While we typically recommend active managers, that is not always the case. At any given time, if we do not believe active management will be as effective in a particular asset category, we focus on minimizing cost and will recommend investing in a low-cost index alternative.
Qualitative Factors Are Paramount
Culling the best candidates from among thousands of managers involves both qualitative and quantitative research.
All our experience and research points to qualitative aspects as being the most important; they will likely affect what happens in the future while performance tells us only what happened in the past. Qualitative factors rely on experience and subjective assessments of an organization (history and ownership structure), its people (management attributes such as knowledge and passion), its portfolio construction (guidelines and risk controls) and its philosophy and process.
Quantitative research – assessing managers by a host of risk-adjusted performance measures – delivers a wealth of statistical information. Choosing a manager that ranks highly by quantitative metrics alone does not by itself improve the probability of getting above-average future performance, based on our experience. However, the data provide a solid framework for evaluating the past and a means of spotting cycles and trends through a repeatable process. While past performance may not predict the future, it remains the most objective measure of a manager’s skill over the long term.
As the result of our extensive study of screening methodology, we have identified refinements to the screening process that we believe will improve our manager selection and thus benefit Altair’s clients.
Highlighting the other primary conclusions of our study:
- Manager excess returns move in cycles and usually revert to the mean.
- Performance periods of over five years are far more important than those of under five years and deserve more weighting in the decision-making process than they are typically given.
- Short-term performance for the most part is useful only as a contrarian indicator.
- Bad short-term performance may present an excellent opportunity to invest.
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Conclusions
Manager selection is a subjective process, not a formulaic one in which a data screen will spit out the correct answer. Our study, if anything, served to confirm that.
But our findings also showed that going against the grain – as in using short-term underperformance as a value opportunity – can work.
Encapsulating the biggest takeaways from our 11-page study:
- Number-crunching is not the most important tool: The qualitative portion of the manager due diligence process is still the key to success.
- Slumps happen: All great managers experience periods of underperformance. Patience with them is rewarded.
- Jumping on the bandwagon of shorter-term outperformance generally does not pay: There is little basis in manager performance data for persistence in manager returns.
- Performance trends average out to 3-5 years: Manager performance cycles – periods of either outperformance or underperformance – vary in length but often fit within this range.
- Outlier periods spell opportunity: Short-term periods of underperformance by top managers may present an opportunity to allocate to managers at attractive entry points.
So how can these findings be applied strategically in selecting and overseeing investment managers?
Start by identifying qualitatively sound managers with superior long-term track records. Study their performance cycles and, counterintuitively, look to buy those that have been in a period of temporary underperformance for the last three to five years. In the same vein, be prepared for a period of underperformance from those that have experienced outlier outperformance for the last three to five years. Our research strongly suggests they will soon revert to previous performance levels.
In echoing the guidance of Graham to sell when a stock is fully valued and buy when it is undervalued, we would give consideration to trimming or even selling the winners among managers and adding to or buying the short-term losers – assuming such moves make sense within the broader qualitative context.
In short, we believe that analyzing past results can indeed be a valuable tool in screening managers. Past performance matters – but not in the way most investors might think.
We believe our findings represent a significant advancement in the manager selection process.
