Whether they like to admit it or not, many investors make the fatal error of backing a fund at the wrong time.
Style drift, manager turnover and poor performance versus the peer group are common challenges for fund selectors. As investment firms centralise processes, bulk up internal research teams and make their due diligence processes even more comprehensive, it is hoped that these scenarios can be identified quickly and avoided.
So what are the danger signals that deter discretionary managers from buying in?
Andrew Wilson, head of investment at Towry, focuses first on a fund’s building blocks. ‘It is important to differentiate vetting a fund manager’s performance from operational due diligence.’
He demands ‘best in class’ administration from asset managers, particularly for fund pricing.
Wilson (pictured) then wants to see suitable controls over those processes. ‘We look for an independent risk team reporting into the chief operating officer, say, rather than the fund manager.’
He is aware the latter have a tendency to react to such teams with a ‘Yeah, noted – now bugger off!’
Wilson seeks compliance officers with ‘teeth’ who can interrogate fund managers beyond their monthly disclosures. ‘It is important as an investor that you have an extra pair of eyes on the fund at all times,’ he said.
‘The only way they are going to get an investment from us is to have an independent risk team. It does not guarantee any extra return, but it does help you sleep a little better at night.’
Similarly Ben Gutteridge, head of fund research at Brewin Dolphin, always checks every link in a fund’s chain, including counterparties, custodians and other providers.
‘We do not have any advantage in knowing what the best systems are, but we will certainly raise those questions,’ with Brewin Dolphin also taking independent advice on the robustness of such systems.
A lack of disclosure is a red flag related to weak systems. Gutteridge insists on transparency for anything going on his buy list. ‘If we can’t compare a fund on a like-for-like basis, we can’t add it to our buy list.’
James Klempster, a fund of funds manager at Momentum Global Investment Management, said: ‘You do not want to be surprised by these things – that is why you do so much due diligence.’
He characterises such work as an extension of his fiduciary duty. At Momentum, the operational due diligence team has power of veto over investments, which helps the firm to push the fund groups they invest with to tighten their procedures.
In the past, for example, Klempster has persuaded funds to change their auditors. ‘You’ve grown as a small company with a certain provider, but maybe they’re not enough to satisfy the due-diligence team.’
Klempster uses a proprietary program to monitor portfolios, which includes tracking not only trades but also the prices at which they are struck. ‘What makes our software powerful is the data we receive from the manager,’ he said. ‘So right from the outset we want to see trading activities.’
This also feeds into a more qualitative assessment of a fund’s dealings. ‘While you cannot rely on past performance for a guide, we do look for past activities as a guide to future activities,’ he said.
Jonathan Webster-Smith, head of the managed portfolio service at Brooks Macdonald, relays that he recently declined to invest in a strategy because of ‘a lack of clarity on a short book within the fund’.
A third requirement is reliable access to fund managers. Wilson negotiates the terms of manager access in advance, and sells funds if they renege. He recalls selling out of a fund run by a large US firm when it failed to adhere to an access agreement.
Gutteridge acknowledges that top managers cannot always be by their phones, but still looks for timely communication from their team. ‘We are not ignorant to the commercial demands of fund managers running large amounts of money. We know Bill Gross won’t come back to us, but we would expect to speak to someone senior at Pimco on the day.’
This connects to another common red flag, flawed behavioural environments. Wilson is an advocate of visiting fund groups to explore the intangibles such as team cohesion. ‘You can only see these red flags onsite.’ He also expects high quality sales contacts. ‘If we’re not getting the relationships from these people, we will sell.’
For Gutteridge, sentiment at a fund group can be further gauged indirectly this way. ‘When you see salespeople depart, you often think they have an insight into managers’ commitment.’
David Coombs, head of multi-asset investments at Rathbones, also watches firms’ profitability for advance warning of problems.
Yet perhaps most importantly of all, each of these issues should be viewed in context.
‘We try not to have too many hard and fast rules or we would end up never investing in anything. There is always going to be the odd rough edge,’ Wilson concluded.