“Improving the odds of success”
by Daniel B. Berkowitz
One thing I have particularly appreciated even in my relatively short one-year tenure with PMA thus far has been firm’s approach to selecting and overseeing its actively managed mutual funds. The title of this memo is in quotes because the investment research team that I used to work with at Vanguard published an old research note called “Keys to improving the odds of active management success”. I continue to use this turn of phrase to describe the philosophy behind investing with active managers because I think it encapsulates the subtleties in only a few short words.
Being successful over long-term horizons with active funds is no easy task. We can, however, “improve our odds of success” by focusing on a few key factors. Though I cannot do our full manager selection process justice in the limited space I have to write, I hope the additional detail below will provide helpful insight for you into PMA’s process. At PMA, we focus on three elements: (1) explicitly defining success; (2) executing a balanced selection and oversight process; and (3) maintaining discipline by evaluating our funds over long-term horizons.
The first step requires that PMA decide, before evaluating any particular fund, what role an active strategy will play in a broader portfolio which may contain both active and index funds (as ours do). It is easy to overlook this step, and success must be defined based on the particular purpose of the potential new fund. For example, success could mean relative outperformance during strong market environments. Or it could also mean downside protection (i.e., a less negative return compared to a benchmark) during poorly performing market environments. Or it could also mean effectively offsetting risk exposures generated by other investments in a portfolio. Complicating this first step is that it is often difficult to find a single fund that can satisfy multiple objectives simultaneously. We at PMA spend much time here considering this initial question before we begin a search for any new fund.
After defining the purpose within the portfolio of a new active strategy, a thoughtful selection and oversight process is required. This firm was founded on the principle of translating sophisticated academic techniques into tangible portfolio construction benefits, in turn, adding value for all PMA clients. With this in mind, I further note that picking active funds will always require a “blend of art and science” (a term often used by firm founder Ed Snitzer). Both qualitative assessment (art) and quantitative techniques (science) are critical components of a well-rounded process. At PMA, we balance both components carefully.
Regarding quantitative techniques for selecting funds, PMA studies a wide variety of investment metrics that provide insight into a manager’s performance. In doing so, we also place emphasis on specific characteristics that are backed by empirical research. In other words, we seek to improve our odds of success by favoring characteristics that have a degree of robustness behind them, in that they have also been vetted by the academic community in some form.
We also pay particularly close attention to a fund’s “style” through time. For example, if a fund operates in the “large-cap value” universe – meaning it is supposed to invest in larger companies that tend to be priced more cheaply (amongst other criteria) – we check the fund’s holdings to ensure it is not drifting into other segments of the market. Funds that do exhibit such “style drift” are problematic in that our portfolios are carefully calibrated to deliver a particular set of risk exposures formed by combining multiple active and passive funds with distinct mandates. Funds that “drift” begin to blur risk exposures for us at an aggregate portfolio level.
From a qualitative standpoint, we conduct an initial, extensive assessment of all of our managers’ investment philosophies, processes, and personnel. We hold face-to face, on-site interviews with a manager’s team before bringing any new fund into our lineup (although in the new “Covid” world we may in the future be required to conduct these interviews remotely). Regarding ongoing oversight, we frequently hosted manager representatives in our office to provide fund updates and answer questions related to performance, firm-level news, and portfolio positioning. Now such conversations take place virtually. Maintaining a pulse on our funds assists us in determining whether a manager is continuing to add value for PMA’s clients—it is highly important to assess funds on an ongoing basis. Doing so also helps alert us to potential red flags that could trigger a manager termination.
The final ingredient to improving the odds of success is often the most challenging: keeping steady over a long-term horizon. Similar in nature to maintaining an appropriate asset allocation through troubling times, this is more difficult than it may seem at first blush. A long-term horizon (i.e., 10+ years) is often necessary to evaluate whether active funds are successful in achieving their objectives. As Larry Swedroe put it in one of the articles that we sent out with our last mailing: “In my 25 years of experience as an investment advisor, I have learned that one of the greatest mistakes investors make is that when it comes to judging performance, they treat three years as a long time, five years as a very long time, and 10 years as an eternity.”
The most challenging part of keeping focused on the long-term is that, in many other aspects of life, we can determine much sooner whether an endeavor has been successful or not. When picking active fund managers, however, even the best of the bunch can experience extended periods of underperformance relative to a market index (or fail to meet some other objective). It is often easier to terminate a manager experiencing short-term underperformance than it is to hold said manager over a long-term time frame with the expectation that performance will improve (and the manager’s process will win out over a full market cycle).
As mentioned earlier, I hope that this commentary provides you with additional insight into PMA’s investment process. Our team is happy to continue this conversation if you are interested in further discussion.
¹ The full whitepaper can be found on Vanguard’s website via this web link: https://personal.vanguard.com/pdf/ISGKEY.pdf
² For example, PMA tends to favor funds with longer-tenured portfolio managers, those that operate at low-cost, and those that maintain a more stable risk profile through time.
³ Larry Swedroe’s article that I am referring to here is titled “If Buffet Were a Fund Manager” from Advisor Perspectives.