Investment performance: what the numbers don’t say

So you’re hiring a new money manager. You have a host of questions to ask. (See our earlier blog post for a list of questions.) You’ll no doubt want to enquire about the manager’s investment performance and fees. But will you know how to interpret the answers? How do you assess what the numbers mean?

It can be complicated, we know. So we’ve put together this piece to help you better understand performance and fees and questions to ask when assessing a potential new money manager.

Is this performance relevant to me?
“Is this performance representative of a portfolio that meets my objectives?” Money managers typically manage a range of different portfolios – with different risk profiles and objectives. Performance for each will be different.

To properly evaluate investment performance, you and the manager must identify the right mandate to meet your objectives. For instance, the two of you might agree that a “balanced portfolio” is appropriate. Once that is settled, the next step is to evaluate the investment performance of the manager’s balanced portfolio.

Unfortunately, often, performance results are shown “fund by fund.” For example, the manager’s performance data may show its U.S. Large Cap Equity Fund as up 15% in 2017. But some important information is missing here. For one, you don’t know what the benchmark return for the year was – maybe it was up 25%. Second, assuming that return is attractive, it does not tell you how much of that Fund was allocated to the balanced portfolio being contemplated for you. And you also do not know if the portfolio was invested in that Fund for the full year.

The performance of a balanced portfolio is critically dependent on the right asset mix – being in the right asset classes at the right time – and avoiding others – and this is a key data point.

Ask about the highs and lows
Circle the highs and the lows on the performance history. You will want to ask the manager to explain the periods they underperformed (relative to their benchmark). Even the best managers will have periods of underperformance so this is to be expected, but you’ll want to understand why.

It is equally revealing, however, to enquire about what contributed to times of outperformance relative to the benchmark. For instance, a manager with a big bet on energy stocks would have looked like a star in 2016. Or another with a big position in the FAANG stocks would be at the front of the pack in the past two years. And of course, a manager with a big position in Canadian cannabis stocks would be enjoying a very strong year this year.

While we all like big returns, you want to be sure that you are comfortable with the risks taken to produce the big numbers. And none of us needs to be reminded that “past results are not indicative of the future.”

The manager’s answers will tell you a lot about the risks that were taken and allow you to assess whether you are comfortable. Most people we deal with do not want to take on any more risk than they need to preserve and enhance their wealth.

What was the asset mix behind the performance?
This is a variation on question two. Make sure you understand the asset mix behind the investment performance. For example, we have seen portfolios described as Income Balanced – in other words, with a more conservative tilt towards income – with 70% invested in equities! In our view, that’s pretty risky for a conservative, income-dependent investor. Again, when you understand the asset mix, you can determine, “Do the investment returns reflect the level of risk taken?” and “Am I comfortable with that level of risk?”

What was the volatility?
Sometimes referred to as “quality of return”, a portfolio’s volatility is a vital component of understanding investment performance. Mathematically, retirement portfolios with a consistent record outlast portfolios with the same average rate of return but higher volatility. Why? Withdrawals made in “down” years leave less capital available to produce income for future years. As well, studies have shown investor behaviour is a major contributor to returns and higher volatility can put that behaviour to the test. Especially for anyone with a history of being ‘trigger happy’ due to biases and fears that have caused them to overreact to market events in the past. You’re looking for a good fit and patience and confidence in your manager’s plan are critical to success. That’s why it’s sometimes best to seek out a manager with a track record of consistent returns – and another reason to probe beyond the numbers.

What will future returns look like?
You should always ask the manager, “What is a reasonable return to expect from this portfolio going forward?” In our view, the next few years will be more difficult to earn the level of returns of the past several years.

Assess fees within context
Don’t be too quick to rule out candidates with higher fees or choose a candidate solely on the basis of lower fees. Once again, it depends on what the portfolio is invested in and how it has done.

If you are attracted to alternative investments (e.g. private real estate, infrastructure, private equity, mortgages, etc.) that help to reduce risk and enhance return, you can expect to pay higher fees. We would not expect to pay a bond manager the same fees as a highly-specialized manager of private debt investments, for example, – even though technically they are both fixed income managers.

The bottom line is, are you getting value for the fees you’re paying? The answer relates to investment performance, risk and volatility of returns – not to mention service and communication and your overall experience as a client.

Compare apples to apples
We recognize that for the lay investor it can be extremely challenging to compare the investment performance and fees of various managers. Some report performance gross of fees, others net. Some report monthly, others quarterly so varying time periods make direct comparisons challenging. Some have long histories, others shorter. Some managers use inappropriate or inaccurate benchmarks for comparison. As we stated above, some present the performance of their individual funds obscuring the overall portfolio mix a client will be invested in. It takes a complicated spreadsheet to plot it all out and even then, you can see there are many qualitative factors beyond the numbers.

Without proper context, one can easily miss the forest for the trees. Hopefully, this backgrounder will help you put the numbers in proper context. Next month, we’ll publish a post on how to assess the ‘soft’ issues of a manager to determine a potential fit.