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 July 2005 What Should a Professional Money Manager do for You?
No, it's not a trick question. On the other hand, the answer probably isn't as obvious as you might think, either. It is, however, worthy of your consideration. You see sometimes things aren't as simple as they seem. Easy answers to what appear to be easy questions can end up costing you real money. This is a prime example. Unless you're using the Salvation Army as your money manager, there are always costs involved. To make it worthwhile, you must believe the benefits of using a professional will more than offset the attendant costs.
This is true whether you have a someone directly managing your portfolio or if you're using a mutual fund. They both have costs, they just get assessed differently. So it's not a question of cost alone, it's a question of net benefits. Less than IdealSo how about this: In the ideal situation, you'd want your money manager to always make you money. After all fees and expenses are deducted, you'd never want to see a statement that showed a smaller balance than the prior one. It doesn't matter if the stock market or bond market goes up or down, your account should grow.Is this a reasonable expectation? Actually it is, but only under certain conditions -- conditions that most of us wouldn't accept. To be profitable in any time frame, a manager must be able to utilize almost any investment in virtually any market. This not only includes stocks and bonds, but commodities, real estate, collectibles, and derivatives from foreign and well as domestic markets. In addition, the manager should be able to establish both short and long positions as the market dictates. Hedge funds attempt to do this but even they are limited to the specific markets and securities in which they have expertise. With little reporting requirements, it's difficult to gauge how successful they've been. Poorer performers quietly go out of business while those that publicize market-beating returns often have short track records. With hedge funds' onerous fee structures (e.g. 2% of assets under management plus 20% of investment profits), even the best find it difficult to produce net profits year in and year out. But even if we could find such funds, most of us wouldn't want to own them. Would you be comfortable if your money manager -- the person controlling your retirement nest egg -- placed all your assets in Malaysian bonds, copper futures, and a short position on European stocks? Conceivably it could happen and it could be the most appropriate mix under prevailing market conditions. Nevertheless, that doesn't mean you'd feel comfortable with it. And that's the problem: Investors are humans and contrary to the capital asset pricing model (CAPM), we aren't always purely rational. While we'd always like greater return and less risk, other more human factors also enter into the decision.
As a result, we tie our managers' hands. Although foreign bonds, futures, and arcane derivatives might be the most efficient mix, we have to feel comfortable with our portfolio as well as our manager's ability. Failing that, we place restrictions on both, reducing our chances of profiting in all situations. Again, in the ideal situation, we'd have complete faith in our manager's ability and turn over total control of our portfolio. Indeed, many managers think (whether they admit it or not) that their performance would be enhanced without client restrictions and interference. But even professional money managers are people, too. Some are better than others, some are dishonest, and some just aren't very good. As long as investors are aware of this, they're likely to want to maintain at least some control over their portfolios as well as their managers. Not all restrictions are irrational, either. Consider, for example, the rapid-fire trading that might be necessary in volatile markets. While a deft manager may be able to produce positive gross returns, taxes and trading expenses will quickly eliminate them. It's not unreasonable for taxable investors to want to minimize transactions. Similarly, time horizons and income needs may suggest additional restrictions. Short-term or income-oriented investors may reasonably limit illiquid (e.g. real estate) or non-income producing (e.g. gold) assets. This can hurt overall portfolio performance when these are the top-performing asset classes, yet it's necessary for the investor's needs. Investors also want to understand what they own. While this is critical if you handle your own investments, it's less so if you trust them to a professional. Even if you do however, you still might feel uneasy to find your entire portfolio invested in those foreign bonds, futures, and arcane derivatives. The easiest way to prevent this from happening, is to eliminate them from the list of potential holdings. Other restrictions may be less rational, but equally limiting for the investment manager. For example, you might not want to sell those stocks you inherited from your father. You might not want to support the "sin industry" by owning securities of tobacco or liquor manufacturers. Perhaps you've never forgiven Germany or Japan for World War II and will never invest in those countries. So although we'd like our money managers to always produce positive returns, we generally prevent them from doing so. Regardless of their basis or justification, they have to operate within the boundaries we give them. In this less-than-ideal situation, we need to expect less than ideal results. The Real IssueSo once again, given that we're human and don't often give our investment managers free reign, what can we reasonably expect of them? How about this: We want them to provide the best returns given their limited universe of potential holdings.For example, if we have a large cap equity manager and big company stocks are out of favor (as they were in 2001 and 2002), we shouldn't necessarily expect a positive return, but instead the best that can be obtained from large cap stocks in that particular environment. That's actually overstating it a little since it's not very likely that any one manager will achieve the absolute best return for any asset class. Perhaps we should only expect them to outperform others with similar directives or an objective benchmark. This is the concept of "relative performance" that became popular in the late 1990s. Realizing that peer groups and benchmarks differ (you wouldn't compare a bond portfolio to the S&P 500, would you?), investors focused on specific measuring sticks.
This approach began to lose its appeal in the recent bear market. Hedge funds and active money managers with the flexibility to venture out of stocks, touted positive absolute returns while even the best equity mangers were under water. You can't, after all, spend relative performance a the grocery store. We'd suggest that positive absolute return is the appropriate expectation for completely unfettered money managers, while positive relative performance is more fitting for heavily restricted ones, especially those limited to one asset class. Given that most of us impose at least some limits on our money managers, we ought to be using some sort of relative benchmark to evaluate them. Although most investors place restrictions on their money managers, few limit them to just one asset category or class such as large cap domestic stocks or intermediate corporate bonds. Instead, the constraints are broader like domestic stocks and bonds. It's here that money managers can add value, but probably not for the reasons you think. When given some leeway, they can create an investment mix from the allowable asset classes and, if all goes right, increase risk-adjusted return through diversification. As we've discussed before however, there's a certain irony here: Many managers generate their best relative returns when they don't do what they claim to. For example, back in the bear market some of the top-performing equity managers and equity funds achieved these honors by going to cash or holding bonds or derivatives. In essence they beat the stock benchmarks by not owning stocks. That's fine for completely unfettered managers, but not for those investors think are restricted to specific asset classes. For the latter, it amounts to an asset/benchmark mismatch. Of course, we usually aren't this restrictive. We let our money managers move between stocks, bonds, and cash so it would have been appropriate -- indeed expected -- for them to overweight bonds and cash during the equity bear market. But in this case, an equity index is not the appropriate benchmark. Instead, it would be more fitting to use a blend of cash, stock, and bond indexes. (For a discussion of how this can be done, please see Blend and Change.)
The Sad FactActually, this is how active managers can truly add value to your portfolio. A study published over a decade ago in the Financial Analysts Journal concluded that the overwhelming majority of a long-term investor's return stems from his or her asset allocation. This is a fairly remarkable finding given that most investors place much greater emphasis on market timing and security selection.Money managers can best help their clients by helping them establish and maintain a workable asset allocation. This isn't necessarily a buy-and-hold approach, although that is a viable alternative. Instead, it can also include "dynamic" or "tactical" strategies as well. The degree of the manager's ongoing involvement is dependent on the selected approach. It also depends on the types of assets used in the process. By their very nature, asset allocation strategies are well-suited to index funds and ETFs. Fewer holdings are required and when necessary, they can easily be traded to adjust allocation percentages. With fewer transactions, trading expenses are also minimized. On the other hand, some investors like to see their individual holdings and follow the companies they represent. This can also be accomplished in an asset allocation strategy although costs of trading individual securities will be considerably higher. An astute money manager may also be able to add value through specific security selection, although the study indicates it has significantly less consequence than the overall asset allocation. Although long-term performance and asset allocation should be their primary focus, many money managers and mutual funds continue to tout short-term results, market timing, and security selection. While these are arguably more interesting than stodgy old asset allocation, they're the sizzle without the steak. Sadly, managers who should realize this, continue to promote market-timing and stock picking. "Asset allocation isn't money management," one professional recently told us. "Any investor could do this at home by himself." Denying the importance of asset allocation doesn't diminish its impact on long-term returns. It's true that well-informed investors could set and maintain their own asset mixes, but they could also pick their own stocks, too. Based on the 1991 study of long-term returns, money managers who focus only on market timing and security selection limit themselves to affecting less than 7% of expected returns. Don't most investors want their advisors to help them with 100%? Other professionals acknowledge the importance of asset allocation yet still promote market timing and security selection. One manager agreed that an investor's specific mix of investments was the most important decision. He even admitted it was the primary focus for his personal portfolio, which was totally invested in ETFs. However for his clients, he still recommended individual stocks and bonds as well as active market timing. "We have to do this," he said, "because to sell asset allocation and indexing would put us out of business."
Now that is truly scary. At the very least you'd expect your money manager to work in your interest. You can make allowances for errors in judgment, or even incompetence, but not for such self-serving deceit. Unfortunately many professional money managers -- and we use the term loosely -- feel this way. Either they don't truly believe in the major role of asset allocation, see it but still feel they can "beat the market" through their superior security selection skills, or like the manager quoted above, don't want to "put themselves out of business" by relying on asset allocation and index investments. That's too bad, especially since there really is a viable role for professional money management. Most investors don't want to spend the time and effort to devise and maintain their own asset allocation strategies. They have other things they would rather do than follow the financial markets, much less individual securities. They need help in these areas and are willing to pay for it. That's the role for the money manager. So what should he or she be expected to do for you? If you've got the assets and courage to let a hedge fund manager have full control, you can expect positive returns in all markets. If, like most investors, you've got a more modest portfolio and limit your advisor to more traditional equity, fixed income, and cash investments, you should expect them to help you achieve a relatively high return relative to an appropriately blended benchmark. They should achieve this by a heavy reliance on asset allocation, low-cost transactions, and quality security selection. It all sounds like common sense, but as long as there are managers who will lead you in other directions -- even while acknowledging the inappropriateness of the strategy -- it's something you need to think about. An uninformed choice of money manager will not only cost you in lost returns, but higher expenses as well. That's not how it's supposed to work. Search this site! Just enter you key word or words:
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K, HERE'S A SIMPLE QUESTION for you: What is money management? What exactly is it that a money manager is supposed to do for you?
