I am fairly confident that my last column didnt convert many of you into index fund investors. Many individuals and institutions continue to pursue active money managers for their stock and bond investments. The hope, of course, is that theyll come upon managers who will beat the market after accounting for all fees and expenses. My belief in indexation only came after many years of hunting for exemplary managers. So while I am a proponent of indexation, its still important to educate those investors continuing to seek active money management.
Youre probably thinking that all you need to do is find is a manager with an attractive historic investment record. Or you may believe that Morningstar or some other services ratings will suffice as a guide to finding money managers. Both these methods virtually guarantee that your investments will not beat the markets. A manager with a strong track record over the last three to five years, or a manager sporting a four or five-star rating from Morningstar is probably destined to trail the market in the next several years. Most of the outstanding performance that attracts investors and garners attention from the financial press is the byproduct of luck rather than skill. The reason is quite simple. Most managers dont have skill or insight when it comes to selecting stocks and bonds. As a result, they may get lucky for a year or two, but the winning streak doesnt last.
While there are dozens of potential questions I used to ask money managers as part of my due diligence process, theres one question that stands above all the rest. Its the question you should ask your financial adviser or broker before agreeing to invest in a mutual fund. Its the same question institutions need to pose when theyre interviewing prospective money managers: What is your edge?
The wrong answers
If your broker or financial adviser cant explain the managers edge in plain English, you shouldnt give him your money. There are several answers that are absolutely unacceptable. For example, if your broker tells you that the money manager is really smart, that is an unacceptable response. First of all, most people in money management are smart. After all, they made the astute decision to get into a business where they can get rich using other peoples money. Being smart is a given, not an edge.
Hard work is another unacceptable answer. Over the years, Ive heard all too many pitches where the money manager was described as incredibly hard working. In my experience, too many money managers have perfect golf tans, which kind of undermines hard work as explanation for their edge. More importantly, hard work alone isnt sufficient to generate superior investment performance.
Complexity is also a non-starter. If the broker tells you that the managers edge is highly complex and very technical, you should challenge the explanation. If he says that the managers investment process is too complicated to explain to a layperson, then chances are that the money manager doesnt have any kind of edge. More likely he has a Rube Goldberg-like investment process that doesnt work.
Verbal warning signs
If your financial adviser tells you that the money manager has a proprietary process, red warning lights should flash before your eyes. Sometimes the adviser will also use a number of other attractive sounding adjectives, such as exclusive, customized, or selective. None of these terms provide you with any real information. The use of the word proprietary, however, leads to a most exasperating conundrum. If you try to follow up and ask the broker to explain the proprietary process, hes likely to tell you he cant discuss it with you because it is proprietary.
Be advised, virtually nothing in the money management business is proprietary. Sure, different managers have slightly different formulas or methods for picking stocks and bonds, but none of them are truly proprietary. The term is slapped on investment products, much as government agencies slap the words top secret on documents. Its a convenient way of preventing you from seeing whats really going on.
In the end, the broker has to be able to explain how the manager picks stocks or bonds on a consistent enough basis so your portfolio will beat the market averages in the future. He has to describe an investment process that unearths critical information about a security that is not reflected in the securitys current price. If the broker can give you an explanation in plain English and you believe him, then you might be on your way to investing with an active money manager. After several decades of asking the question, Whats your edge? and getting unsatisfactory answers, I simply gave up.
Andrew Silton is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/