August 31, 2011

3 Steps to Determine if a Portfolio Manager Really Has an Edge

“CNBC is a primary source for our stock ideas.”

OK, while we haven’t heard this exact statement during a portfolio manager interview, perhaps you have learned, as we have, that some investment strategies are more compelling than others. 

“Investment edge” is an oft-quoted term by investment managers that loosely translates to “I have a way to beat the market.”  As a provider of due diligence services, it is a claim that we take seriously and it triggers a natural reaction to dig deeper. 

The following line of questions will help you discover if your manager has a defendable investment edge that is truly differentiated and sustainable. To bring this exercise to life, we will profile the LSV Value Equity (LSVEX) fund, which is managed by a team that we believe has such an edge.

Step No. 1: What inefficiency are you attempting to exploit? Is there research or evidence that suggests that the inefficiency actually exists?

The manager’s response will likely mirror their philosophy statement.  For example, certain managers, including LSV, strongly believe that investors can be emotional and irrational when it comes to financial matters, so they attempt to exploit this inefficiency through behavioral finance and/or disciplined quantitative strategies. 

It is important to try to understand why the manager believes that there is a payoff to focusing on this inefficiency.  Review the research the manager has done to understand in which economic and market environments their strategy works best, or conversely, fails to generate strong performance. The mere presence, or absence, of this research says a lot about the thoroughness and thought the manager applies to their investment process.

LSV presents historical research that suggests investors have persistently mispriced stocks by forecasting past performance too far into the future, and mistakenly associated good companies with good investments regardless of valuation. Their research is robust, thoughtful, exacting and frequently revisited.

Step No. 2: Does a strength exist as it specifically relates to the manager's ability to identify and exploit this inefficiency?  Is there any differentiation or

distinction to the investment strategy from the rest of the world?

These questions really get to the heart of whether or not the manager possesses an investment edge.  Even the traditional pockets of inefficiency such as distressed securities, spinoffs and micro caps can be picked over. Look for the following areas of strength that can separate a manager from the pack: informational advantages, execution, and experience.

Informational advantages are the most commonly cited investment edge.  For many bottom-up fundamental managers, they simply work harder, get more creative, or devote more resources to unearthing the information that they need.  This is an advantage that is often touted among international funds where portfolio managers and analysts reside in the geographic area of investment.

A smaller population of managers possesses the execution trait.  Some are able to turn an average process into above average results because of tightly controlled execution. Strategies intended to exploit trading inefficiencies are especially prevalent among fixed income managers.

In LSV’s case, we believe the portfolio management team’s academic background coupled with the depth of research and sophistication of its quantitative process supports its ability to continually exploit these inefficiencies.  While there are numerous managers that either have quantitative processes or behavioral finance-based investment philosophies, LSV’s model is proprietary, sophisticated, and the portfolio risk controls are differentiated. 

Step No. 3: Is there consistency/persistence of their “edge”? How does the manager adapt to the “disappearing” inefficiency?

Over time markets evolve and competitive forces can negatively impact arbitrage opportunities within an investable universe. Managers should systematically measure their results for proof that what they believe is effective, continues to be so.  LSV performs research to continually refine inputs to the model although the basic philosophy has never changed.   

Also, beware that an “edge” itself can fade due to external forces such as capacity.  For instance, a micro-cap manager that was able to outperform with a $20 million portfolio five years ago will likely have a more difficult time doing so today with a $200 million sized portfolio.

Putting It Together

Those managers who are able to clearly articulate their investment edge and who are able to backup their claims with robust research, are the managers that you should be more inclined to have confidence in going forward. Most advisors, and clients alike, will agree that this is a critical aspect of any investment manager evaluation.

Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.

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