The single most important aspect of selecting a money manager is the Investment Selection Process. WWK’s Investment Selection Process encompasses ten important factors, both quantitative and qualitative, in developing and maintaining a solid fund lineup. Our process exemplifies how and/or why certain funds are selected.
Quantitative Factors
Performance
In the industry, a fund’s performance is often not reviewed in sufficient detail. We compare how a fund performed versus a relevant benchmark as well as performance within its peer group. We consider the percentile ranking the fund received over different periods of time, including the 1, 3, 5, and 10 year periods. We target funds in the top quartile in their respective categories. For example, if a fund had a ranking of 20, it outperformed 80% of the funds in its category. We avoid funds whose long-term rankings fall in the bottom quartile of their respective category.
Consistency
In addition to performance, we prefer a fund that has performed well throughout a series of time periods. Although past performance is no indication of future results, the longer record typically includes the ups and downs of a full market cycle, whereas the short-term may not. It is imperative that fund managers demonstrate the ability to consistently perform well throughout different market cycles. Overall, we place more emphasis on the longer time periods.
Management Tenure
This is probably the most overlooked category. After we have determined that a fund has a good track record, there are two additional considerations – the factors that went into their track record and the probability that those same factors will continue to work in the future. Although other components aid a fund’s performance, the manager or managers make the final investment decisions. If a fund has a great ten-year track record and the manager leaves, how relevant is the track record he or she produced?
Risk
After the unprecedented, back-to-back bear markets of 2008 and 2000-2002, many investors have altered their view regarding risk. The last 10 years, appropriately labeled “The Lost Decade,” provided negative returns for the equity markets for the first time since the Great Depression. WWK has always considered risk an important factor for investment decisions. A fund’s beta and standard deviations are excellent measures of risk. Standard deviation is a true measure of volatility. It also enables us to compare funds with different investment objectives.
Costs
As always, the costs paid by the investor for the management services should be reasonable. Most investors look at the cost to purchase a fund instead of the cost of owning that fund over 5 or 10 years. The single biggest fee that is overlooked is the fund’s annual expense ratio. This fee is taken directly from performance; therefore the client never sees the fee. It is very rare to find a fund with a high annual expense ratio with above average long-term performance. We also take into account any wrap, insurance or annuity fees involved with a product.
Qualitative Factors
Fund Family
It is important to understand the style and tendencies of a fund family. Increasingly, mutual fund families are liquidating and merging funds. Conveniently, this can create “survivor bias”, the ability for fund families to eliminate a bad track record distorting their actual investment results. We consider this, as well as whether a family is inclined to have high portfolio turnover or manager turnover, and their reputation for meeting the fund’s stated investment objective.
Investment Philosophy
The management company’s investment culture may truly be the most important factor. The quality and breadth of the research, as well as the internal incentive to share ideas, has a tremendous impact on the way a firm manages money. Some funds are managed strictly on computer models and balance sheet statistics. Other funds purchase outside research, while others conduct their own. The global nature of a firms’ research department can play a role as well. Consequently, too many intangibles go unaccounted for in model-based investing. Additionally, the best research is often not for sale. Therefore, we prefer management firms that conduct proprietary research.
Research Analyst
The specific role and experience level of the research analyst is an important factor in the success of a fund. Typically, the analysts are the most knowledgeable experts in their respective sector. They provide great insight to portfolio managers because they are out in the field meeting directly with the management, suppliers, and competitors. It is even possible for these analysts to develop ongoing relationships with mid and upper-level management, giving them further insight into the capabilities of the executives running the company. Due to the importance of the position, we prefer to see long tenures in this field.
Stability
The size and stability of the investment organization certainly plays a role in our selection process. Typically the resources of a large organization are an asset. The larger investment firms are able to attract some of the brightest and most talented managers. We also consider the impact of whether a family is publicly or privately held. In light of the “Mutual Fund Scandals of 2003,” more emphasis has been placed on the integrity of the fund family.
Size
It is not necessary to be a large fund to be successful. However, the advantages of economies of scale can be significant. Their buying power typically provides cost savings to shareholders. We find the quality smaller shops tend to be niche players. It is also important to analyze the effects of the fund’s ability to handle large flows, whether positive or negative. How a firm handles large inflows after a period of strong performance can have a notable impact on future investment results. Large flows will cause some firms to close funds. Conversely, the negative effect of net redemptions can cause liquidity problems and can force a fund to sell securities at an inopportune time. All of these factors need to be taken into account when analyzing each fund.