How to Select a Money Manager

Questions to ask:

The first thing to remember about professional money managers is that repeated research has shown that 70 – 80 percent of these guys can’t beat their assigned benchmark.

Secondly, “Managed Accounts” are a way to make something look “special” while eliminating certain regular third party measurement and scrutiny.  The “marketers” intimate unique access to very talented managers and that may, or may not, turn out to be the case.  Some of these guys are merely clones of a larger fund that they run, usually incurring higher fees, less diversification, and always a conflict of which pool of money gets priority.  Some others are just not very talented.

People, be they professionals or friends, tend to recommend managers who have done well recently.   As a consequence, your portfolio is likely to be managed by someone whose best years are behind them.  Repeated research has shown that top quartile managers who “beat their benchmark” for 4 quarters consecutively are more likely to end up on the bottom quartile within a very short time of the exceptional performance.

Now ---- Questions to ask

When meeting with the representative the first thing you should ask is whether the person is an investment advisor or a salesperson.

 A registered investment advisor who works on a fee-only basis will have nothing to gain from commissions and is sworn to act as a fiduciary. That means putting your interests before his.

Who exactly will work with me after I invest in the portfolio? What is my access to the manager?

The person that you are working with should be the person that will be there to answer questions and understand any moves that are being made in the portfolio. Make sure that they are not just asset gatherers. Access to the manager is not available in all situations, but would be a favorable situation to look for.

Are you performance compensated? If yes, how?

This question will help you begin to understand the different factors that influence decisions that are made. Be skeptical of portfolio

managers that get annual bonuses based on performance. This will, at times, cause mangers to make radical decisions or take unnecessary risk toward the end of the year that could have tax consequences for you.

What are your 1, 3, 5 and 10 year returns on your portfolio? What have been your worst (4) quarters? What have been your best (4) quarters?

The rate of return on an investment, expressed as a percentage of the total amount invested. Rate of return is usually, but not always, calculated annually.

The return on an investment, including income from dividends and interest, as well as appreciation or depreciation in the price of the security, over a given time period, usually a year is referred to as total return.

This will allow you to start to understand what type of risk, volatility, and return on your money that you can reasonably expect.

What is the length of tenure of the person(s) making the investment decisions?

When looking at returns over measured periods of time if the person most responsible for those returns is not presently in the same position all the historical data including performance is not worth the paper upon which it is written.  A subtle but important question is the age of the person making the investment decisions because, as a person ages, they may travel more, work less, and let the assistant managers play a larger role in the decision process.

How do you control risk?

Risk is the quantifiable likelihood of loss or less-than-expected returns. This question is going to begin a list of questions that will give you a deeper understanding of how the manager is going to manage your money.

How do you feel about being entirely in cash?

**Being in cash is the first step in managing risk. You want a manager that is not afraid to move your investment money to cash to avoid market losses

How do you approach asset allocation?

Asset Allocation is the process of dividing investments among different kinds of assets, such as stocks, bonds, real estate and cash, to optimize the risk/reward tradeoff based on an individual's specific situation and goals is asset allocation. This is a key concept in financial planning and money management.   Style specific managers will rightfully answer that they are one piece of the allocation pie and the entire allocation is up to you to design.

Is your portfolio truly style specific or is there a measure of drift?

For “all cap” managers the answer will be that there is no style drift because we don’t adhere to a style.  For style specific managers the answer should be that there is no style drift. 

What are your thoughts on the Modern Portfolio Theory?

**Modern Portfolio Theory (MPT) is a strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially as measured by alpha, beta, and R-squared. This theory recommends that the risk of a particular stock should not be looked at on a standalone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio. The theory goes on to state that given an investor's preferred level of risk; a particular portfolio can be constructed that maximizes expected return for that level of risk.   Proper diversification is predicated on MPT and is the foundation of managing risk toward a specified return goal.

The next 7 questions dig deeper into how the portfolio is constructed.

What is the alpha of your portfolio?

Alpha is a coefficient, which measures risk-adjusted performance, factoring in the risk due to the specific security, rather than the overall market. Look for a high value for alpha, that implies that the portfolio has performed better than would have been expected given its beta (volatility). Basically this tells you if you are getting paid to take on the extra risk.

What is the beta of your portfolio?

Beta is a quantitative measure of the volatility of a given stock or portfolio, relative to the overall market, usually the S&P 500. Specifically, the performance the stock or portfolio has experienced in the last 5 years as the S&P moved 1% up or down. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile. Look for a low beta.

What is the R-squared on your portfolio?

R-squared is a measurement of how closely a portfolio's performance correlates with the performance of a benchmark index, such as the S&P 500, and thus a measurement of what portion of its performance can be explained by the performance of the overall market or index. Values for r-squared range from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation. This value will tell you how much of the return of the portfolio is management and how much is just general market performance. You would prefer a number closer to zero than closer to one.

What is the standard deviation of your portfolio?

A statistical measure of the historical volatility of a portfolio, usually computed using 36 monthly returns. More generally, a measure of the extent to which returns are spread around their average. Look for a lower standard deviation. This means lower volatility of the portfolio.

What is the Sharpe Ratio of your portfolio?

Sharpe ratio is a risk-adjusted measure developed by William F. Sharpe, calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance. Look for a higher number.

What is the Sortino Ratio of your portfolio?

Sortino ratio is a variation of the Sharpe ratio which differentiates harmful volatility from volatility in general by replacing standard deviation with downside deviation in the denominator. Thus the Sortino Ratio is calculated by subtracting the risk free rate from the return of the portfolio and then dividing by the downside deviation. The Sortino ratio measures the return to "bad" volatility. This ratio allows investors to assess risk in a better manner than simply looking at excess returns to total volatility, since such a measure does not consider how often the price of the security rises as opposed to how often it falls. This ratio may not be available. It is not as popular as the Sharpe ratio. A large Sortino Ratio indicates a low risk of large losses occurring. Look for a ratio that is close to the expected rate of return the better.

What is the Treynor Index of your portfolio?

The Treynor Index is a measure of a portfolio's excess return per unit of risk, equal to the portfolio's rate of return minus the risk-free rate of return, divided by the portfolio's beta. Sound fun? This is a similar ratio to the Sharpe ratio, except that the portfolio's beta is considered the measure of risk as opposed to the variance of portfolio returns. This is useful for assessing the excess return from each unit of systematic risk, enabling investors to evaluate how structuring the portfolio to different levels of systematic risk will affect returns. This basically will tell you how much of the return is based on the risk the manager takes.

Systematic Risk (Market Risk) - Risk that is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against systematic risk because different portions of the market tend to under perform at different times. This is usually addressed in the asset allocation of the portfolio.

Do you use or try to mirror Indexes in your portfolio? If yes, what is your Tracking Error?

An Index is a statistical indicator providing a representation of the value of the securities which constitute it, for example, the S&P 500. Indices often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured.

When using an index or any other benchmarking strategy, the amount by which the performance of the portfolio differed from that of the benchmark. In reality, no indexing strategy can perfectly match the performance of the index or benchmark, and the tracking error quantifies the degree to which the strategy differed from the index or benchmark.

What you are looking for with this question is the manager tracking an index. If he is he is not adding much value as a manager.

Is your portfolio tax-efficient?

**This question will help you begin to understand what the annual tax consequence of owning the portfolio historically has been. The next four questions will help you gain a better understanding.

What are the historic capital gains on your portfolio? What is your short vs. long term gains on average?

Capital gain is the amount by which an asset's selling price exceeds its initial purchase price. A realized capital gain is an investment that has been sold at a profit. An unrealized capital gain is an investment that hasn't been sold yet but would result in a profit if sold. Capital gain is often used to mean realized capital gain. For most investments sold at a profit, including bonds, options, collectibles, homes, and businesses, the IRS is owed money called capital gains tax.

A capital gain or loss on an investment which was held for less than some minimum amount of time (often a year and a day). A short-term gain usually results in a higher tax rate than a long-term gain.

A capital gain or loss on an investment which was held for at least some minimum amount of time (often a year and a day). A long-term gain usually results in a lower tax rate than a short-term gain.

What is your average turnover rate?

The turnover rate is the rate of trading activity in a portfolio of investments, equal to the lesser of purchases or sales, for a year, divided by average total assets during that year. The percentage of a portfolio's assets that have changed over the course of a given time period, usually a year. Turnover ratio for a portfolio is calculated by dividing the average assets during the period by the lesser of the value of purchases and the value of sales during the same period. Portfolios with higher turnover ratios tend to have higher tax consequences.

How do you convert paper profits into real gains?

This question and the next question are close in nature. Paper profits are unrealized capital gains. What you are looking for is to see what the manager’s strategy is on selling an investment that has performed well.

Do you sell on percent loss or percent gain? What is that percent?

This will help you begin to understand the manager’s investment philosophy. You ideally want to find a manager that doesn’t sell a good performing investment just because is gains a certain percentage. You want to find a manager that reevaluates the position after a certain percentage gain, not automatically sell a winner. The same goes for percent loss, reevaluation, not automatically sell the investment.

What is your investment philosophy?

Investment philosophy is overall set of principles or strategies that guide a manager. Examples include fundamental, technical, value, growth, and contrarian. When he or she answers the question have them explain what “value” means to them. These words have different meanings to different managers. Have them explain in detail how they look for opportunity.

How are the transaction fees paid for?

Transaction fees are the cost for placing a trade in an account. It is important to you to know how these are handled. If your money manager absorbs the costs of transactions it could weigh the decision of whether or not to place a trade. For example, a manager has 200 accounts and they all hold stock XYZ. If the manager pays the transaction fees and it costs him $20 a trade, he might not sell because of the cost to himself. If the individual accounts pay the fees it has no weight on the managers decision of holding the position in XYZ.

At what point do you close your portfolio to new investors?

You want to find out if the manager is ever going to stop taking new money and also how personalized the portfolio is for you.

Are you in anyone’s wrap account program?

A wrap account is an account in which a brokerage helps an investor find a money manager in exchange for a flat quarterly or annual fee, which covers all administrative and management expenses. This will help you clarify is the manager is an asset gatherer or a money manager.