When hiring active managers, many advisors look for the star rating on Morningstar rather than using solid criteria. Advisors and investors should focus on active managers who skillfully allocate capital to their best investment ideas. Passive investment options are widely available to investors who want market returns with low fees. Active managers must add value by acting in clients’ best interests by allocating capital to attractive risk-adjusted investments to increase returns and more than justify fees.
“Wide diversification is only required when investors do not understand what they are doing. Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
– Warren Buffett, Berkshire Hathaway
Look for Value managers that fit the following criteria. They are:
- At least 10 yr performance history
- Low expense ratios.
- A single manager because it demonstrates ownership of fund and avoids group think
- Manager does not over diversify and is a best idea or focus fund
- High cash positions- Shows that a manager is actively searching for the best opportunities
- Consistently low P/E ratio on holdings (ex. S&P 500 P/E = 19.8)
- Managers who eat their own cooking- meaning that they have their own money in their fund
- Low turnover rate- demonstrates convictions in holdings
Briefly covered is each of the 8 criteria below:
- Long term survivability: A minimum of 10 years of performance history gives us a long term look into how the manager performs through varying market cycles. We prefer to see at least one market crash and rebound to see how the manager reacts and makes their investment decisions.
- Low cost of management: We expect low cost management of the fund just like we would expect low cost management for a company. The more value that can be driven from the fund the more profitable the fund is for its managers and its shareholders.
- Single Vision and Responsibility: Single managers are less likely to be convinced and/or moved from their originating ideals. When a single manager makes a decision he/she alone is responsible for that decision. When a team of managers make a decision, it is difficult to place blame or praise (identify ownership) for an investment decision. Single managers by definition have more riding on their decisions and thus spend more time during the due diligence portion of their investment hypotheses.
- Does not Over-diversify: Volatility-aversion of investors and lack of in-depth research influence fund managers into creating over-diversified portfolios, diluting the alphas of their best ideas. This leads to the widespread underperformance of mutual funds compared to their benchmark indices after deducting the expenses and fees. Our definition of risk, defined as “permanent capital impairment”, forces us to disregard short-term volatility and focus on making the best investment decisions based on fundamental research.
“There is no sense diluting your best ideas or favorite situations by continuing to work your way down a list of attractive opportunities.”
-Joel Greenblatt, Gotham Capital
- Holds cash when deals are unavailable: Good managers stay true to their ideals and hold fast when markets do not provide good investment opportunities. In elevated markets we see good value manager’s portfolios having increasing cash positions. When managers cannot find good companies to re-invest their capital into, they are forced to hold cash because they are unwilling to deviate (drift) from their investment objective.
- Focus on finding “On Sale” companies: Value mangers are always trying purchase companies at a price that is lower than what their intrinsic value is. One way of identifying these companies is through the Price to Earnings Multiple. A low market price in relation to a company’s earnings signifies a cheaper price than if the market realized the company’s intrinsic value.
- Eat their own cooking: We place high importance on whether or not a manager has any of his/her own money invested along-side their shareholders. We find it hard to invest with a manager who does not believe in their own product.
- High Level of Conviction: Low turnover signifies a high level of conviction in the positions within the fund. When a manager has low turnover he/she is not transitioning in and out of specific positions because he/she is confident in their research and investment hypothesis.
“It talked about a couple of studies, including the best-performing fund from 2000 to 2010, which was up 18% a year even when the market was flat. The average investor in that fund went in and out at the wrong times on a dollar-weighted basis to lose 11% per year. Meanwhile, the statistics for the top-quartile managers for that decade were stunning: 97% of them spent at least three of those 10 years in the bottom half of performance, 79% spent at least three years I the bottom quartile, and 47% spent at least three years in the bottom decile.”
-Joel Greenblatt, in reference to his book The Big Secret for the Small Investor during an interview with Barron’s.com