Clients often ask me what methods I use to research and analyze funds. This is a numbers business, so first and foremost I look at quantitative factors. But while the numbers are great at telling me what a fund has done in the past, they aren’t always great at predicting whether it can deliver above-average returns with below-average risk into the future. That’s where I turn to qualitative factors, which can be quite illuminating, but which need a bit of intuition and interpretation.
Quantitative screens are all about the numbers, and are very useful in eliminating funds that do not exhibit the risk-reward characteristics that I believe make good investments – those that have a history of delivering above-average returns with below-average risk. Historical data, properly analyzed, can tell you a lot about a fund’s performance, risk, and consistency. But to get an idea of how a fund might do in the future, you have to look at some factors that are not so easily quantifiable and make some subjective judgments.
This process is called “qualitative analysis,” and is a “deeper dive” that takes a more detailed look at the fund, the manager, and how it is managed. At a minimum, I focus on three key areas: people; process; and risk management.
1. People
This involves much more than just reading the biography of the fund manager. Don’t get me wrong, it is extremely important to understand the qualifications of the person running the fund. You will want to know that they have applicable experience in the fund’s mandate. You don’t want a manager with only U.S. equity experience suddenly managing an emerging market portfolio. Each market and sector has its own intricacies that only those with experience in it can fully appreciate.
But in addition to the manager’s experience and qualifications, I also want to understand the dynamics around how the fund is managed. For example, is the lead fund manager the only person involved with the fund, or does he or she have a team of analysts and portfolio managers they can use to help review investment ideas? Some shops will run a very collaborative team type of approach, while others will have a more silo type of operation. One is not necessarily better than the other, but it is important to know how the team functions.
Another reason to look at the resources available to a manager is to give an indication of whether or not they can effectively implement their investment process. For example, if a fund is managed using a very research-intensive, bottom-up approach, there had better be a fairly large team involved to assist the manager. Without a team, the manager can get spread pretty thin, pretty quickly.
For example, a few months ago, I reviewed a hedge fund that was run by two individuals. They claimed they reviewed more than 2,000 companies each year and did almost all the research themselves. With all due respect, there is no way two individuals can review 2,000 companies at the level of detail claimed. If they do review that many companies, there is a very high probability that they will miss something that could be material to the fund. Needless to say, I took a pass.
2. Process
When I look at the investment management process, I am looking to gain an understanding of how the fund is actually managed. To do this, the first thing I need to understand is what the fund is, and what it is trying to accomplish. Once this is known, I need to understand how the manager buys and sells securities for the fund.
The next step is to understand where managers get their investment ideas. They may use a top-down approach that looks at the big picture first, or it may be a more bottom-up process that looks at each investment individually. For some funds, for example, a Canadian large-cap fund, the idea generation can be pretty basic, while for more specialized mandates, the idea generation can take many innovative and interesting forms.
Once they have their investment ideas, it is important to know how the managers evaluate them. Again, it may be a more top-down type of review, or it may be a process that involves building a detailed financial model and valuing the company using such methodologies as discounted cash flows, determining the net asset value, or even using the dividend discount model. Once this is understood, I like to focus on what specific criteria they use to decide whether an investment is added into the fund.
While the buy criteria are important, it is perhaps even more important to understand the manager’s sell discipline. Once I know what triggers are used to sell a stock out of the portfolio, it helps me understand whether the process is very regimented, or more of an intuitive approach. This also allows me to understand the amount of trading that takes place, and how positions are bought and sold into the fund.
3. Risk controls
Perhaps the most important aspect of portfolio management is risk management. Knowing what precautions the fund has in place to protect investors’ capital is very helpful in understanding the total risk picture.
I like to get an idea of what limits are in place surrounding such things as what size companies the fund invests in, minimum and maximum sector exposures and geographic allocations. I also like to know what systems the company has in place to ensure that the managers follow the investment guidelines of the fund.
At this stage, if possible, I always like to see how the manager’s interests are aligned with the investors. I look to see how much of the manager’s personal money is invested in the funds they manage. I also like to ask about how the managers are paid. I like to see situations where they must invest their bonuses in the funds they manage. This helps to keep the managers on the same side of the table as the investors, and it also helps to keep them at the firm, so you don’t see a lot of manager turnover.
Bottom line
Throughout the process, I try to make sure that there is consistency between what the qualitative information says and what the fund’s performance numbers show me. If there is a significant disconnect along the way, the fund is removed from further consideration.
Courtesy Fundata Canada Inc. © 2015. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
