How I Evaluate Investment Managers
This post will probably be too brief, but here goes. The most important aspect of analysis is trying to gauge any sort of sustainable competitive advantage. Qualitatively, do they really have something special going that other are unlikely to imitate? Second, do they fit their paradigm? If they are growth investors, do they use momentum? If they are value investors, are they willing to be wrong for a while?
Third, how do they handle lesser questions like earnings quality? Do they look at cash flow, free cash flow or earnings, and how do they justify their answers? Do they have a decent decisionmaking process, given that managers that trade less tend to do better?
Finally, have they been successful? Do they win, and do they win for the reasons that their methods would favor? Good track records that emerge for reasons other than managerial intentions are unlikely to be repeated.
Now what don’t I look at? Sharpe ratios and other quantitative measures of risk. The measures aren’t predictive of future performance, and the risk adjustment is too short term in nature. These measures are backward looking, and not indicative of future performance. Better to spend time sweating over how a manager chooses assets, limits risks, etc., than to focus on quantititive measures of risk that have no relation to long term performance.
June 27th, 200811:14 am at
David, this makes sense, but I’m a little confused by your comment about quantitative risk metrics. Can’t things like the Sharpe ration, alpha, etc. be applied meaningfully to longer terms? Granted the measurements are backward-looking, but so is a track record….
June 27th, 200812:12 pm at
brevity can be a hallmark of wisdom sometimes. i can do nothing but agree for the most part especially the qualitative aspects of profiling a manager. unfortunately its easier said than done for most cases since one does not get enough of a window to evaluate before a manager gets too hot and closes.
June 27th, 20088:04 pm at
To your list of reliable predictors, I would add:
1. High manager co-investment, or other forms of incentive alignment and a history of good stewardship of shareholder capital
2. Low “structural” costs : tax ratio, expense ratio, trading costs related to strategy, slippage from asset base being too large
3. High active share. This adds the most informational value when you can be confident of their sustainable competitive advantage.
I also think a focus on managers who achieve their long term performance by conserving capital better than their peers stacks the odds in your favor. I increase my bias towards these types of managers when the prior probabilities for the performance of their asset class is unfavorable.