Why Fund Managers And Clients Need To Be In Harmony To Create Client Wealth
In most fund management structures, such as, open-ended mutual funds or managed accounts (also labelled as separately managed accounts (SMA), portfolio management services (PMS), portfolio advisory services (PAS), managed portfolios etc.) the fund manager is collaborating with the client in creating wealth.
The client takes the decision to invest his money under the guidance of the fund manager. After this, the client has no role except deciding whether to add more money or redeem. The fund manager’s role is to use their search strategy and analytical and valuation tools on the chosen investment universe to select the best stocks to construct a portfolio which is likely to create wealth over the long-term.
As an aside, let us address the issue of short-term performance and wealth creation. To our knowledge the only way to create short-term performance is through trend-following and, possibly, boosting it further with leverage, i.e. margin trading or using derivative instruments. While there are numerous traders, hedge fund managers, high-frequency traders (HFT), quants and algorithmic traders and their trading strategies, most of these are effectively trend-following, albeit, sometimes with quite elaborate and sophisticated-sounding strategies which might use lots of computers and software programs.
We don’t think that this short-term performance is sustainable in the long-term and eventually these traders are likely to stop performing. One of the simplest proofs is that one can hardly find a trader who has compounded their wealth to billionaire status. Further, one can read about how some of those handful might be due to sheer luck in this talk which Buffett gave at the Columbia Business School in 1984 to commemorate the golden jubilee of Graham’s book on value investing, “Security Analysis”. “Black Swan” by Nicholas Taleb also talks about how the performance eventually fizzles out within a few “bad days” which happen once in 3 to 5 years.
So, let us discard the thoughts of using short-term trading strategies to create wealth.
The long-term wealth creation, too, is not easy. Once a fund manager has created the portfolio, the portfolio could provide positive returns or negative returns in the short-term. Typically, the client is monitoring this performance on a monthly or quarterly basis. When the client sees reasonably large positive returns during the holding period, the client feels good about investment decision, the fund manager and the portfolio. In this case, there is continuance of the portfolio and possibly more capital might be added.
When the client sees negative returns in the portfolio, they will, typically, start blaming the fund manager, start doubting their strategies and want to redeem. In an open-ended structure redemption is easy. In this case, the collaboration has failed, and the joint venture of the client and the fund manager has resulted in destruction of wealth.
In any period less than 3 to 5 years, the market movements dominate, and the portfolio of a fund manager will fluctuate with the markets. Sometimes it is more distressing for the client when the market index is positive, and the portfolio is negative. These are times when a few large-cap stocks which dominate the market index are showing positive returns while the rest of the stocks in the market are negative. During these times, the momentum-following fund managers or the fund managers who buy the same stocks as the index, seem to be doing well and all others seem to be performing badly. The client could redeem if they are allocated to other fund managers. Again, the joint venture has failed to create wealth.
The only way a client and fund manager can create wealth, is that first, the fund manager should have a strong risk-aware and risk-averse investment philosophy. This philosophy should also be understood by the client. Second, the fund manager should have a well-defined and original search and selection strategy based on the investment philosophy. Third, the fund manager should have a sophisticated analytical and valuation tool box. Conservative valuation carried out with a non-consensus, analytical perspective should yield potential stock candidates for the portfolio where the market value of the stocks is much lower than the conservative valuation. Fourth, the fund manager should have a highly structured portfolio design framework so that no single stock or sector can dominate the risks and returns of the portfolio. Bear in mind that there is no “sure shot” stock which one should pick which is going to outperform. These are naïve ideas and, both, clients and fund managers should understand that each pick means that “the fund manager is X% confident that the stock is undervalued by Y%”. That is why a single stock (or a highly concentrated portfolio of less than 10 stocks) doesn’t make sense. Again the client and fund manager should understand this. Fifth, the fund manager should be adhering to their investment philosophy and investment strategy in a demonstrable manner. The client should be aware of how to evaluate if the fund manager has created a portfolio which is consistent with their investment framework. Further, the fund manager can help the client in demonstrating this with sharing relevant data points about the portfolio fundamentals and valuation benchmarks.
If the client now understands the portfolio design and wants to evaluate a portfolio which has negative returns in the short-term or is underperforming, the client can use these criteria and assure themselves that the investment strategy remains consistent with what was stated at the outset by the fund manager and which had convinced the client on their own due diligence that it could create wealth in the long-term. In that case, the client should continue holding the portfolio for the long-term to create wealth.
Of course, if the portfolio is inconsistent with the initial investment strategy which was presented by the fund manager, the client should redeem.
It is clear that creating wealth is not a simple outsourcing decision by the client but a collaborative effort between the fund manager and the client. If the client doesn’t understand the investment philosophy and that the portfolio could underperform and even have negative returns in a holding period of less than 5 years, then the chances of creating wealth over the long-term are low.
The burden on the client is to be able to understand how to evaluate the investment strategy consistency during challenging times. Without this wealth cannot be created, except by chance or luck.
Dr. Vikas V Gupta, CEO and Chief Investment Strategist, OmniScience Capital
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Disclaimer:
Past performance is not necessarily indicative of future results.
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