Simple Criteria for Looking at Active Management

The following is a post from a reader who's a CFP at Hong Tran Financial:

Many people that read Free Money Finance are passive investors that use index funds for the investment management.  I thought it would be interesting to write about “the other side”, that being the active money managers.  I focused on what are some of the criteria that make a good money manager as well as a good active fund.  I hope you enjoy it!

Mutual fund money mangers are evaluated on various metrics, but the most common is performance.  Unfortunately, as the disclaimers you see on investments state, past performance is no guarantee of future performance.  So what do you look for with performance or any other measurement when trying to find a good money manger?  Here are some metrics that I hope will help you get a better grasp on this:

• Performance – Rather than use 3 or 5 year performance (what some consider “long term”), I suggest using at least a 10 performance.  The reason for this is that a typical market cycle can last up to 10 years (or occasionally longer).  Using a 5 year performance can get you the high end of the market or the low end of the market, but it may not get you both.  A great example is the technology boom of the late 1990s.  From 1995 – 1999, most equity funds did well along with the market.  This was a drastic difference the following years when the same funds showed huge losses during the technology bust.

• Assets under Management – The bigger the fund is, the harder it is for the fund to buy significant stakes in the companies it wishes to own.  For example, a fund that manages 50 billion dollars wants to have a 1% stake in the companies it owns.  This equates to a 500 million dollar investment. However, if some of the companies that it wishes to own have a market cap of 1 billion dollars, than the fund is forced to buy half of the company which would drive the stock price of that company up before the fund can acquire the 1% position for itself.  The fund would have to pay significantly more for the stock or else buy a smaller position than it wants.

• Management Tenure – Management tenure at the fund is as important as the long term performance of the fund because the money mangers are going to be the ones that dictate the investments.  If they just joined the fund recently, the past performance was not attributed to their skills, so is less indicative of what you can expect.

This is by no means a complete list of what to look for, but I hope it gives you a starting point to evaluating money managers.

Comments

[Matt]

In general, a fund with strong long-term performance and long management tenure is going to have an unwieldy amount of assets under management, because investors chase performance (and have already beaten you to it).

So how can you pick a good actively managed fund? Simple: don't. Active management is bunk.

But if you really insist (or are forced to because of who your employer picked to run your 401(k)), here are a few good criteria:
1) Loads. Don't ever pay loads. For every load fund, there's a no-load fund that's just as good. Be especially wary of salesmen; a deal that comes to you is rarely a good deal.
2) Expense ratio. The lower the better. You can never be assured of future performance of the underlying investments, but you can get a good idea of the fees you'll pay. It may not sound like much, but 1/2% can make an enormous difference in the returns of long-term investments. You have to keep an eye on these to make sure they don't jack them up later too.
3) Other fees, such as minimum balance, transaction fees, etc.
4) Turnover. The lower the better. This is less of an issue in tax-sheltered accounts, but less turnover still indicates a manager more inclined to buy and hold.
5) Cash holdings. If it's supposed to be an equity fund, you don't want to see them holding much cash. That indicates that the manager is trying to time the market (or isn't quick enough at investing incoming money in equities). Time IN the market is more important than timing the market.
6) Style. That is, what does the fund invest in (e.g. small cap value, large cap, REITs, precious metals, emerging markets, etc.) You need to keep a close eye on your actively managed funds, because managers sometimes drift to other styles that have little resemblance to what you thought you were investing in.

I completely left performance off the list. I did that on purpose.

http://www.slate.com/id/2160236/

[Matt]

I just wanted to add one more thing for those who are forced into less-than-optimal fund families because that's who runs their 401(k) or 403(b): Do the best you can against that list, but no matter how bad it is, it's virtually always best to capture the full match your employer offers.

[Ted Valentine]

What about alpha? Aren't many active managers paid based on how they do compared to their benchmark indexes?