For many people making an investment decision is about choosing an investment management house, often defaulting to large brand names.
“That’s not the correct way to do it,” says Sygnia head of manager research Duane Gilbert. “Manager selection is the last step of the process. The starting point is assessing your liabilities, savings and time horizon and then working out what kind of product or combination of products can reasonably be expected to provide you with the appropriate risk/returns profile. Once you have that, 90% of your work is done,” he says.
“When you have figured this out, your default investment choice should consist of cheap passive investment products.”
Selecting a manager
The challenge for an investor comes in selecting active investment managers. “This is really a function of the conviction you have that the manager can outperform the index.”
Gilbert points out that it’s not enough to beat the index; they need to beat it consistently by more than the fees they charge for their service.
When it comes to selecting a manager, larger and boutique asset managers both have their pros and cons.
“You can’t really be a stock-picking manager when you are large,” says Gilbert.
He says being able to derive value out of picking shares gets harder the larger a fund gets. There is the danger the manager could move the market if they opt to sell, which requires them to be cautious when it comes to making investment calls. “As they grew from a small manager to a large house, they had to adapt from being stock pickers to asset and sector allocators.”
When it comes to outperforming the benchmark, smaller funds have a significant advantage because they can choose to ignore sector themes and focus on stock-specific drivers, Gilbert says. Small managers are able to more effectively play in the small and mid-cap space, exploit off-benchmark positions and make the occasional wrong call, which they can reverse quickly.
He points out that to take a 4% position in a R50-billion fund, the fund manager would need to take a 20% stake in a company with a market capitalisation of R10 billion. By comparison, a R5 billion fund would only need to take a 2% stake in the same company to get the equivalent exposure.
This does not mean there are no disadvantages in selecting a small manager. “Small managers come with their own risks. They tend to not have well-resourced research teams and there is typically significant key man risk.” This is where the business is so dependent on an individual that it would collapse without him or her. Another risk is poor housekeeping – smaller managers sometimes come with a higher degree of operational risk.
Even so, Gilbert notes there have been some outstanding small fund managers who have delivered great performance over several market cycles. “They are not necessarily smarter or more intelligent than the guys in the large houses, they just have a bigger opportunity set.”
Though there have been some stellar performers, there have also been some who have managed capital horribly. “There are some brilliant boutiques that manage capital really well but I’ve come across managers that do not and, unfortunately, these are not isolated cases.” There is a wide disparity in the calibre of management.
All else being equal, Sygnia prefers smaller boutique managers to larger investment houses. Although – from an average investor’s perspective – smaller managers can be seen as being more risky, Sygnia has a strong manager research team and a rigorous on-going due diligence process to ensure that it picks the best out of a large universe. “Manager selection is a full-time job for a lot of people here. That is why we are confident playing in this space.”
It is important to remember that active management is a zero sum game. For one manager to outperform an index, it requires another manager to underperform. “If you are confident in your ability to select a manager that will outperform then do so, but be aware of the risks involved. If not, then stick to index trackers. Over time they are bound to outperform at least half of the active managers out there.”