25 investment gurudownloads.hindawi.com/journals/cjgh/2000/437191.pdf · form of investors...

Stalking the elusiveinvestment guru

Gabriel Lee BComm CIMA

Once again, it is that time of the year! This time, notonly is the New Year upon us, it is also the dawn of a

new millennium. Because we all made it and the purportedY2K bug has not caused the bank to deposit a few milliondollars extra into our bank accounts by mistake, maybe weshould use this time to really take stock of our lives, startanew and recommit to working on all those New Year’s reso-lutions.

Inevitably, ‘taking stock’ includes the subject of money,and someone is bound to say,

We should really look at that investment portfolio of ours

and see how we have done in the past year. First, we will

need to drag out all of our investment account statements for

the past year, maybe all the bank statements too; sit down

and sift through all those buy and sell confirmation slips;

consolidate all the registered retirement savings plan ac-

counts; determine what the portfolio started the year with

and what it is worth now; and then compile, tabulate, ma-

nipulate and estimate our way into a performance number.

Did I mention taking into account all the contributions and

withdrawals from the investment accounts? And how about

factoring in all the income generated by interest, dividends

and capital gains? Okay, whose brilliant idea was this any-

way? Oh, let us just forget it! If we pick up the newspaper

and see how our mutual funds have done, that should give us

a good enough idea of how we did overall, should it not?

Often, this scenario plays out with the portfolio beingbriefly scrutinized and the performance of any mutual fundsowned duly noted. Inevitably, the next day, heads start toroll. Either the advisor who recommended that ‘dog’ of a mu-tual fund takes the brunt of the dissatisfaction or a decision ismade to fire the bum who runs that mutual fund, leading to areduction, sale or switch of units. After all, if the currentstrategy is flawed and is producing poor or substandard re-

sults, something must be done to turn the proverbial boataround and get it going in the right direction, does it not? Isthat not the whole reason for going through this exercise inthe first place – to get rid of the lack-luster performers andclean out the pigs and dogs from our yard?

Does any of this sound familiar? Have you ever fallen intothe trap of hiring or firing money managers, that is buying orselling mutual funds, based on the recent past performance ofthose managers?

Past experience suggests that at least some of you havecontemplated using this strategy of portfolio realignment, ifnot actually practised it. Your rationale may not have beenbased entirely on your own dissatisfaction with fund perfor-mance; your investment advisor may have recommendedthat you switch or sell one of your underperforming funds.

In this article, I share some of the proven, procedurallyprudent methods of searching for, selecting and retaining in-vestment managers – those who you may be confident willnavigate your assets astutely and conscientiously throughturbulent market conditions. Because it is more challengingto rein in the risk and harness the superior returns of stock orequity managers than bond managers, the remainder of thisdiscussion focuses on equity money managers.

LET’S TALK GURUMany people believe that there are ‘gurus’ such as WarrenBuffett, John Templeton and Peter Lynch with whom we canentrust our hard earned money, and that they in turn will leadus to the Mecca of high returns and low risk, with little or noeffort on our part. But even these so-called gurus, with theirexceptional performance records, endure periods of time dur-ing which their approaches do not work.

Consider the closed-ended mutual fund BerkshireHathaway, basically an investment holding company run byWarren Buffett that trades on the New York Stock Ex-

Can J Gastroenterol Vol 14 No 1 January 2000 65

Gabriel Lee is one of Canada’s leading investment management consultants. In 1997, he became the eighth Canadian to receive the designation ofCertified Investment Management Analyst (CIMA) from the Investment Management Consultants Association in conjunction with The WhartonBusiness School, University of Pennsylvania. Gabriel is currently an Associate Director with ScotiaMcLeod Inc and is in charge of the InvestmentManagement Group in Edmonton. He can be reached at 888-814-4223, toll free, in North America.

Correspondence and reprints: Mr Gabriel Lee, Associate Director, ScotiaMcLeod Inc, Scotia Place, Main Floor, Suite M26,10060 Jasper Avenue, Edmonton, Alberta T5J 3R8. Fax 780-413-7477, e-mail [email protected]

PATHWAY TO PROSPERITY

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66 Can J Gastroenterol Vol 13 No 9 November 1999

Lee

change. In 1993, an investment of US$10,000 would havebought you one share in this company. As of early December1999, each share was worth US$55,000, meaning that youwould have enjoyed the awesome rate of return of nearly28% per year, compounded annually (Figure 1).

Mr Buffett became immortalized after the publication ofthe book The Warren Buffett Way: Investment Strategies of the

World’s Greatest Investor, by Robert G Hagstrom Jr in 1994(1). He can be considered an investment guru in every senseof the word. Warren Buffett was riding on the crest of suc-cess, notoriety and popularity that few had enjoyed beforehim. Retrospectively, Berkshire Hathaway was the ‘hottest’investment fund out there.

So what is the problem? What can possibly be wrong withan investment that has made 28%/year for the past sevenyears? In short, absolutely nothing – if you bought it in Janu-ary, 1993 at US$10,000. However, if you bought the stock inmid-March, 1999 at a price of US$81,100 instead of in 1993,your resultant rate of return would have been a sobering mi-nus 33% over the past nine months. Is Mr Buffett no longer aguru? Has he lost his touch? How could investing in such apool, managed by one of the world’s richest men with somuch talent and foresight, ever have turned out bad? The

answer to that question may lead us to an understanding ofthe elusive nature of the guru.

Money managers are not all created equal. Some have aunique ability to interpret market conditions and act deci-sively when confronted with uncertainty, and have the expe-rience and acuity to execute precisely at the right time amajority of the time. Many managers have a proven track re-cord, have demonstrated their ability to manage moneythrough adverse conditions and have a proven process of se-curity selection leading to superior results. However, I do notsubscribe to the illusion that those same managers will pro-duce large, positive rates of return every year indefinitely.The challenge, then, is to discern accurately whether the re-sults exhibited by a given money manager are a product of in-vestment acumen, a successful process of identifying andselecting superior investment opportunities or a byproduct ofluck and fortunate timing.

STOP THE INSANITY!If you have ever had a bout of insomnia, you may recognizethis phrase used by weight loss and self-esteem guru SusanPowter in her infomercials. At times, I wish we could rewriteher script to include a commentary on ‘investment insanity’.

North Americans have been raised in an environment offast food. We demand quick fixes physically, psychologicallyand even spiritually. Patience and perseverance seem to belost and forgotten virtues. We seem to have no time for suchfolly when faced with our overbooked schedules.

In the investment industry, this urgency manifests in theform of investors impatiently seeking short term perfor-mance results. Large or small, neophytes or veterans alike,investors often fall prey to the lure of judging investmentmanagers purely by their short term performance numbers.With inexperienced investors, performance is often the onlycriterion used in their investment manager search and selec-tion process.

This is understandable because historical performance isone of the few analytical tools easily available to most inves-tors. This is also very unfortunate because the use of perfor-mance numbers as a measure of investment managementsuccess sometimes leads to a myopic focus on short term re-sults, subsequently leading to flawed and counterproductiveconclusions.

Dalbar (2) has shown that the average United States eq-uity mutual fund produced a cumulative return of 285% inone 10-year period during the study but that the average mu-tual fund investor in those same funds enjoyed only a 58% re-turn (Figure 2). Why?

Investors are too often attracted to an investment withthe hope of high returns and fast results. When the latest‘hot’ fund or manager fails to satiate their need for perfor-mance immediately, those same investors can become criti-cal and impatient. Inexperience and misappropriated zeallead investors to ‘buy high’ when their sense of greed encour-ages them to choose a manager with exceptional recent per-formance and to ‘sell low’ when their patience evaporatesand their fear of investment failure grips them.

Figure 1) Berkshire Hathaway’s metoric rise to stardom. BRKA Berk-shire Hathaway Inc Del. Reproduced with permission fromwww.bigcharts.com

Figure 2) Investment returns versus investor returns. Reproduced withpermission from Northern Trust Global Advisors. Data from reference 2

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These basic human traits of fear and greed may haveserved us well in our evolutionary past, but inability to curbthese impulses leads to unwise investment decisions. Sellingcurrent holdings to buy last year’s ‘hot’ manager has provedto be an expensive mistake that individual investors havemade again and again.

According to the Dalbar study (2), investors who buyno-load mutual funds, usually without the advice of invest-ment advisors, typically sell their holdings within the first 18months of purchasing them. This demonstrates a lack of thepatience, confidence or fortitude required to judge the in-vestment over at least one complete market cycle, which isusually four to six years.

This is understandable, particularly if the investor boughtthe fund impulsively because they had not sought out orbeen provided with the necessary quantitative and qualita-tive selection criteria. If a purchaser is not confident in theirinitial selection of a particular mutual fund, the people man-aging that fund, and the timing and appropriateness of thepurchase, it is not surprising that a subsequent ‘knee-jerk’ de-cision to sell might precipitate.

Unfortunately, all too often investment management de-cisions are made in the ‘spur of the moment’, usually in astate of emotional distress or elation.

HERE IS WHAT NOT TO DOAs I suggested in previous articles, successful investors learnto avoid making large mistakes on their portfolio. Such mis-takes are identified below.Attempting to select a money manager without first havingdeveloped an investment policy: One cannot abdicate theresponsibility of setting goals, objectives and guidelines withwhich to manage a portfolio. “The plan – Formalizing yourunique ‘investment policy’” (3), highlighted the importanceof clearly identifying and quantifying the parameters of an in-vestment portfolio. Needless to say, a manager search is futilewithout the guidance of a well conceived plan of execution.An investor attempting to choose a money manager withoutan investment policy statement is analogous to a producerholding a casting call for a new play before a script is everwritten. How can you know what talent to look for?Setting unrealistic performance expectations: Even gurushave poor years. Chasing the latest returns without under-standing why they may have occurred can lead to disappoint-ing results. I have seen that twenty-eight per cent annuallyover seven years does not guarantee exceptional performancein the following year. Unfortunately, the heavy flow of capi-tal into last year’s ‘hot’ managers on an after-the-fact basis,and the subsequent disappointing results, demonstrates thisinvestor axiom time and time again.Neglecting to use style diversification within an asset class:Style refers to a money manager’s chosen area of specializa-tion. The particular style practised by a money manager maybe analogous to the specialty practised by a medical doctor. Agrowth-style stock manager tends to focus on companies withsuperior prospects for earnings and expansion. Value manag-ers, on the other hand, favour companies that are selling be-

low their intrinsic worth. It may make sense to diversify intoboth growth and value styles within the stock component of aportfolio because employing different investment styles canreduce fluctuations in returns. Diversification helps reducerisk, whether it is applied to the number of stocks held, man-agers employed or asset classes used. Do not, however, simplychoose a large number of managers in an attempt to make useof this strategy because all of them may be employing similarstyles of investing. More on style later.Selecting money managers without following a due dili-gence checklist: Selecting money managers without follow-ing a due diligence checklist can lead to a host of relatedmistakes: performance being compared to irrelevant invest-ment benchmark or indexes (such as comparing an interna-tional equity manager’s performance with that of theToronto Stock Exchange index); peer comparisons beingoverlooked (or not comparing the risk and returns of a man-ager to its peers with the same investment objectives); andother important search criteria being overlooked (resultingin, for example, duplication of managers with the same orsimilar styles of investing).

STYLE MATTERSUnfortunately, the stock market is not a machine that movesin regular and predictable patterns. If it were, everyone couldrely on executing one set of governing principles that wouldultimately lead to success and financial fulfillment. The con-cept of an ‘efficient market’ dictates that if one approachwere clearly superior, everyone would quickly embrace andadopt it, and it would inevitably lose its advantage.

Accomplished money mangers each have their own dis-tinct, well articulated philosophy about how money is madein the market. Equally important is that each has the convic-tion to stick with that philosophy through thick and thin.Because of this adherence to their chosen investment ap-proaches, such managers inevitably encounter times of poorperformance and uninspired results

As I alluded to above, most of the philosophies of equitymanagers fall somewhere on a continuum between the fol-lowing two primary ‘style’ types:

� Growth managers tend to choose more exciting,innovative companies with leadership positions in theirmarkets – companies whose stocks can soar if conditionsare right. Growth stocks are those with higher thanmarket (measured against the Standard & Poor 500 orToronto Stock Exchange 300 stock index) price to bookvalue ratios, higher price to earnings ratios and lowerthan market dividend yields. Some well knowncompanies that fall into the category of growth stocksare Microsoft, Wal-Mart, Pfizer and Nortel. Since 1994,growth stocks have dominated the market in the UnitedStates, and growth managers have basked in thelimelight of success, enjoying frequent appearances ontalk shows and interview requests.

� Value managers tend to look for companies that are in atemporary slump, possess hidden assets or are in mature


Pathway to Prosperity

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industries unappreciated by analysts on Wall Street orBay Street. Value stocks are those with lower thanmarket price to book ratios, price to earnings ratios andhigher than market dividend yields. Phillip Morris,Xerox, Maytag and Scotiabank are examples of valuestocks. In stark contrast to the trend set by Americanmarkets, value stocks in Canada far outperformedCanadian growth companies from mid-1995 tomid-1997 (Figure 3).

Although these are the primary style types of investmentmanagers, they are by no means the only styles available tothe public. Of the myriad of styles of managers available, theones most commonly used by Canadian investors are small,medium and large capitalization managers (each type avail-able in growth as well as value styles); core yield managers;international managers; real estate managers; and hedge al-ternatives managers, followed by the extreme ends of thegrowth and value spectrum – managers who are either mo-mentum or contrarian based.

Why is any of this important in conducting managersearches? An equity manager’s investment style is by far theprimary determinant of their short term performance, mean-ing that it is far more important which style(s) you selectthan which manager(s) you select (Figure 4). Next to assetallocation, discussed in my article entitled “Common mis-

takes of affluent investors and how to avoid them” (4), styleallocation may be an investor’s most important decision.

As a practical example, consider the historical trend ofcontrasting performance patterns demonstrated by Cana-dian value stocks versus Canadian growth stocks over thepast two decades (Figure 3). If one were to look only at theshort term performance of a particular manager as a selectioncriterion, the wrong conclusion would likely be drawn aboutthe capabilities of that manager. In other words, the worstgrowth manager may at times outperform the best valuemanager and vise versa.

Finally, note the counter-cyclical nature of historical re-turns when comparing large capitalization Canadian stockswith small capitalization Canadian stocks (Figure 5). Thesestyles serve to counterbalance one another in a similar waythat a value bias offsets a growth bias. In truth, the correctidentification and interpretation of these cycles should notprompt an astute investor to eliminate completely one styleof investment or another. One may seek merely to over-weight one bias more than another to attempt to maximizereturns.

Overall, relying on just one style of money managementresults in a significant degree of volatility because that stylegoes into and out of favour. Knowing the style as well as thetrend of that style will prove to be an invaluable asset in se-lection of a money manager and in the ongoing decisions tocontinue with or to replace that manager.

WHAT IS NEXT?Once a working understanding is achieved of how invest-ment styles and cycles interact within a portfolio, initialmanager selections may be made, and detailed due diligenceand analysis rendered. At this point, most clients hand theremaining responsibilities to a consultant for further distilla-tion, and sit back and await the final proposal.

I say ‘consultants’ because the information, time and ex-pertise required to proceed past this juncture is beyond thescope of most individual investors. Many consultants employthe following analysis to distill further the most ideal invest-ment management candidates for a client’s portfolio (Figure

68 Can J Gastroenterol Vol 14 No 1 January 2000

Lee

Style90%

Active Management10%

Style 90%

Figure 4) The importance of style. Reproduced with permission fromNorthern Trust Global Advisors. Data from reference 6

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Growth* vs. TSE 300

* TSE 300 Total Return Index/Barra Value and Growth Indices: 12 month rolling returns relative to the TSE 300 Index.

Figure 3) Canadian value stocks versus growth stocks. TSE TorontoStock Exchange

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*Large Stocks represented by TSE 35, Small Stocks represented by Nesbitt Burns Small Cap Weighted Index: 12 month rolling

returns relative to the TSE 300 Index.

Figure 5) Canadian large stocks versus small stocks. NB Small CapWtd Nesbitt Burns Small Cap Weighted Index; TSE Toronto StockExchange

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6). The ‘four Ps’ refer to people, philosophy, process and per-formance, and serve to accentuate the successful candidatesand cast an unsavory pallor on the rest.

WHAT SHOULD INVESTORS DO?Because it is impossible to predict accurately future invest-ment results based on past returns, individual investors canfollow many of the same criteria that large sophisticated pen-sion plans use when selecting the managers for their portfo-lios, including:

� Selecting experienced, disciplined managers who use adistinct, well articulated philosophy of investingthrough changing market conditions, a disciplinedinvestment strategy and process that have performedwell over a long period of time;

� Using mangers that use concentrated portfolios. Selectmanagers who limit the number of holdings in theirportfolios so that they invest only in their very bestideas;

� Making sure that it is very unlikely that the fund willchange managers any time in the foreseeable future. Inits purest essence, selecting a money manager is simplybuying the skills of a particular manager or portfolioteam. If that manager leaves or the team chemistry isaltered, a completely different fund with differentcharacteristics and returns may result. Consider hiringonly managers that own their own firms or at least havelarge equity stakes in the companies for which theywork. Either way, the less likely the possibility of changein personnel, the better.

� Selecting only managers who do not have too muchmoney to manage. A recent study conducted byHurley et al (5) clearly shows that investing money is adiseconomy of scale. That is, the more money that amanager has under management, the harder it is for himor her to get superior returns. In Canada, where equitymarkets are small and trading relatively light comparedwith those in the United States or numerous otherforeign markets, the ability of a manager to buy and sellstocks without altering the price of that stock arelimited. Canadian equity managers who manage morethan $1 billion to $1.5 billion, depending on their styleof management, seem to reach a threshold where sizebecomes a problem.

In general, the use of multiple managers with multiplestyles put through the aforementioned screens should pro-duce the best results.

IN THE NEXT ARTICLEAfter all the exhaustive research and contemplation, hope-fully, a group of uniquely skilled and tightly focused moneymanagers are retained to actualize your financial aspirations.If you have followed all the steps of the investment manage-ment consulting process, as outlined in my previous articles,

the likelihood of you making a significant and costly mistakewill be minimized.

Now that you have hired these managers, does it meanthat they will always be the best candidates to steward yourfinancial aspirations? Of course not. There are many reasonsto reconsider working with a particular manager. A changein your investment objectives upon retirement, a period ofunexplainable performance characteristics whether they beexceptionally good or exceptionally poor, or a change in amanager’s personnel mix all call for additional scrutiny to beplaced on existing managers.

In the next article, I will complete the investment man-agement consulting odyssey by describing the last and finalstep of the six-step process – monitoring and evaluating yourportfolio on an on-going basis. It will be entitled “The vigi-lant sentinel”.

In the meantime, treat your current stable of managerskindly because your search for the elusive guru may lead youright back to your own portfolio.

REFERENCES1. Hagstrom RG Jr. The Warren Buffett Way: Investment Strategies of

the World’s Greatest Investor. New York: John Wiley & Sons, 1994.2. <Http://www.dalbar.com/quantitative_analysis.shtml> Boston: Dalbar,

Inc, 1997.3. Lee G. The plan – Formalizing your unique ‘investment policy’. Can J

Gastroenterol 1999;13:779-83.4. Lee G. Common mistakes of affluent investors and how to avoid

them. Can J Gastroenterol 1999;13:521-4.5. Hurley MP, Fuller TG, Kanner YN. The Future of the Financial

Advisory Business and the Delivery of Advice to the Semi-AffluentInvestor. Dallas: Undiscovered Managers, 1998.

6. Sharpe, WF. Asset allocation: management style and performancemeasurement. J Portfolio Manage 1992;18:7-19.


Pathway to Prosperity

PEOPLE

• Skill and talent• Focus on investment process• Strong convictions and motivation• Stability, integrity, capacity• Size

• Top-down, bottom-up• Security universe• Benchmarks• Research and valuation• Sources of ideas• Portfolio construction• Diversification• Trading

PHILOSOPHY AND PROCESS

• Portfolio characteristics• Industry “bets”• Risk exposures• Style analysis

–custom benchmark–consistency

• Transactions/turnover

QUALITATIVE QUANTITATIVE

PERFORMANCE

1 Return–absolute, value added, risk adjusted

2 Consistency–batting average, up/down markets, attribution

3 Risk–volatility, tracking error, downside–distribution of returns

Figure 6) The manager selection and due diligence process

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