Focusing on past performance is often the first and only port of call for investors when trying to differentiate between investment managers. But there is no guarantee that past performance can be replicated over the long term.
Performance is only one of four ‘Ps’ that should be considered when selecting an investment manager. The other three are philosophy, process and people. A consistent philosophy and process, with the right people to implement them, should allow for more replicable past performance into the future.
The investment philosophy is how an investment manager thinks about investments. It is the DNA that drives the way an investment manager invests. If you understand your manager’s investment philosophy, you should also be able to understand their investment decisions. Importantly, for performance to be replicable in future, the investment manager should have a consistent investment philosophy with that which delivered the past performance.
But investment philosophies are only as good as their application. To judge the merit of an investment manager’s philosophy, it is important to assess their behaviour relative to their philosophy over a long period of time and preferably through several market cycles.
The process is how the investment philosophy is implemented in client portfolios. The process should be rigid enough to allow for effective implementation of the philosophy, but should also allow for some flexibility to allow the manager to take advantage of market conditions. Once again, consistency in the investment process is an important indicator as to whether or not an investment manager is capable of repeating past performance.
Investment management is a business of people - the third ‘P’. Having the right people with the necessary experience is crucial for the implementation of the investment philosophy and process.
The fourth P – performance – is the outcome of the other three Ps. It is important to assess the performance over a long enough timeframe, preferably through the investment cycle, to determine whether or not the implementation of the other Ps has actually delivered over time.
Understand the particulars of the portfolio you select
Investment managers are effectively custodians of clients’ savings and investments. This responsibility is governed by the mandate of a particular portfolio which covers a broad range of issues from return objectives and performance benchmarks, to liquidity requirements, fees and specific investment parameters with which the investment manager must comply.
An equity-only fund, for instance, can only invest in equities even if the manager believes all equities are expensive. This is where it becomes vital for investors to select portfolios that are aligned to their investment objectives.
An investor who wants short-term capital preservation but is invested in an equity-only portfolio could be disappointed as its mandate is likely to be contrary to this objective. It’s crucial to have realistic expectations for the returns from a particular portfolio.