Selecting active investment managers in emerging market equities

August, 2012 Print

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This article has taken a long time to write, and not just the time taken to organise and prioritise the issues and decide what and how to write. It is about the time it has taken me to learn and understand the issues and to develop a set of coherent beliefs; to analyse what those beliefs mean in terms of my behaviour when selecting an investment manager and then to assess how to apply this in the emerging market equity space. So I make it 50 years and counting.

I have spent 25 of those years as a fund manager and, during this time, have had to develop and refine my own investment process. This process has been challenged by my peers and investment consultants, and I’ve also had to manage and challenge the investment process used by others. My investment manager selection has been reasonably successful over the long term and I believe this owes much to the way I think, and an upbringing which encouraged questioning and challenging the status quo.

My experience has taught me that there is no single, correct investment approach which guarantees success. Investment managers develop an investment process based on their intellectual understanding of investment theory and experience of how their markets behave, but also based on their own values and beliefs. A successful investment manager does not just have a theoretical investment approach but a philosophy in which they have invested considerable intellect and which reflects, to some extent, their beliefs as an individual.

Because of this, selecting a good investment manager is about understanding their motivations and investment philosophy. They should be able to state their investment process coherently, explain why they believe it should work, show that past performance reflects this process and discuss the circumstances in which the investment process will fail.

So why select an active manager? This should not be a foregone conclusion, given the alternatives, which include indexed funds, and breaks down into three parts: 1. What is the level of inefficiency in the asset class? The ability of a manager to add value at a specific skill level will be lower, the more efficient the market. 2. Can skilled managers exploit this inefficiency? There may be reasons managers cannot exploit market inefficiency; for example, low liquidity or high regulation. 3. Are you able to select these skilled managers? For example, you may not have the time or skills to analyse and then monitor prospective managers.

For emerging market equities, there remains a high level of interference in the flow of information, and in the management and regulation of investments. We can therefore safely assume that the allocation of capital is sub-optimal and that there is enough uncertainty to allow active management to add value.

My personal view is that the current level of global economic uncertainty will continue to lead to a wider dispersion of active manager returns than has been the case historically and that, in emerging markets in particular, the flow of information and the level of political interference help to ensure that a well-resourced active manager with a coherent investment process can add value.

An allocation to emerging market equities is based on the belief that, in “emerging”, these countries will grow faster than the developed world and, in liberalising their economies, will allow private enterprise to flourish. This should lead to a faster growth of investments over the long term. However, as they experience this faster growth, the risk of surprise from changes in regulation or political power and patronage will be greater and the sources of information less standardised than we experience in developed markets (the Eurozone crisis notwithstanding!).

The final issue to consider is whether your fund has the ability to select and then manage an active manager and, most importantly, to give that manager the greatest opportunity to add value.

This means that you must be prepared to allocate a reasonable amount of time to selecting and then monitoring the manager, you must be ready to accept the greater volatility of performance that active management is likely to bring, and you must give that manager some certainty of tenure so that they can build and maintain a portfolio in line with their investment philosophy.

Pension fund money has a great advantage in that the future cash flows of the scheme are relatively predictable. This allows the fund to commit capital over the long term. Don’t lose this advantage by approaching manager selection as a short-term operation based purely on the last quarter’s relative performance against an index. You need to understand how a manager aims to create value and write the mandate such that their ability to do this is not unnecessarily constrained. This means building an element of trust and dialogue, which takes time.

So what should you look for when selecting an investment manager? Unfortunately the information which is most readily available can often mislead, since performance history over the very short term means little. A one- or even three-year history of outperformance is unlikely, alone, to prove ability and much of it may be down to luck, not judgment. Even when a manager can prove skill, it is set within the market environment of the past, rather than the future.

So, if we have few facts to guide us, what can we analyse? What can we deduce from the information that is available and how can we maximise the probability of selecting a manager who will outperform in the future? There are four “P”s to consider – Power, People, Process and Portfolio.

Power: Where does the power lie in the organisation wishing to manage your money? Who controls the company? Who benefits from fees derived from managing your money and are their interests aligned with yours? Are they motivated by increasing the assets under management, or by making the existing assets outperform? Is there a sales culture or an investment culture? How stable is the ownership structure? All these questions are about understanding the ethos of the company you are entrusting your investments to. There should be some matching of their corporate ethos with your own, and valid reasons why your money or the product you are investing in is important to them.

People: Who are the important investment thinkers within the company? Are they involved in managing your money? How committed to the company are they? How are they rewarded? These people should be non–consensual, aiming to be right rather than popular. They should have a good understanding of risk and take risk in a controlled manner. This is about making sure the people who have defined the investment process you are buying into will still be there to manage your money and continue to be motivated by doing so successfully.

Process: The investment process should be sensible, coherent, robust and simple. It should be easily explained and supported by the use of past examples of success and failure. There should be a clear analysis of where and why market inefficiencies exist, and the sources of value which are being exploited. The manager should show that they are adequately resourced to exploit these, while you should feel that the manager believes in what he is selling and is committed to this investment process. Past performance should be used to validate the investment process, showing in what market circumstances the process worked and when it failed.

Portfolio: There should be strong links between portfolio structure and investment beliefs. Individual investments should stand out as logical within the context of the investment process. The portfolio construction process should be robust and built by the key investment thinkers. There should be strong riskcontrol processes.

I approach manager selection in any asset class by looking at the four “P”s. However, for emerging markets there are a number of additional issues. The markets you are investing in are diverse – economically, geographically and from a regulatory point of view. How will your manager cope with this? Are they sufficiently resourced – not just with fund managers and analysts, but operationally?

The markets may be illiquid, in particular the constraints on your ability to repatriate your money may be affected by political change – as in the suspension of trading in Egypt during the political crisis of 2011. Are you able to cope with this?

By considering all these issues I believe you can begin to understand an investment manager and assess whether they can fulfil your requirements.

However, I’m afraid that there are no easy answers. There is no alternative to investing time and effort in understanding how your prospective manager works and why they believe they can manage your money successfully.

Set out in advance what you are trying to achieve, and discuss with your manager what success and failure look like. Have a system which is ready to withdraw your money at short notice because the process I have detailed above means that failure is not about three successive quarters of underperformance but is about a loss of trust or change in Power, People, Process or Portfolio. Any change in the investment thesis you established when selecting your manager should lead you to review the position. Expect openness and honesty from your managers, and base your relationship on the understanding you built up when the manager was initially appointed. Does their response to the issues of today fit with their explanation of their approach to investment as previously described? If not, expect an effective explanation.

Above all ask yourself whether you still believe in your manager. If not, it may be time for a change.

John Arther
Senior Adviser
AllenbridgeEpic Investment Advisers

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