Morningstar Advisor - October/November 2012 - (Page 27)

2 We trade too much. For all of the talk you hear about the importance of long-term investing, many of us transact quite a bit. Why? Let’s face it—clients might only think we’re doing our job if we hire and fire managers. “Throw the bums out and get me somebody who knows what he’s doing,” some of us imagine you bellowing. The problem is less nefarious than it sounds; the mechanism for hiring and firing managers is so engrained in the manager-research process that it’s almost indistinguishable from manager research itself. Clients are seeking reassurance that there’s a methodical approach to conducting manager diligence, which many define as the process of hiring and weeding-out. So, manager research can come to turn on furnishing that comfort, in the form of a system that spits out actionable ratings like buy, watch, and sell. There’s nothing wrong with this—we use a similar type of system ourselves in managing mutual-fund portfolios for our clients. But the bells, whistles, and infrastructure of manager research can have a self-reinforcing effect—clients seek manager-researchers out at least partly because of the value they place on the “widget” they use in making hiring and firing decisions; many of us, deferring to our clients, obediently follow the rules. Solution: Explain the buy/sell discipline, put what actually took place, clients can better calibrate their expectations. It’s also important to correctly position the manager-research methodology itself. Namely, that it’s a tool for organizing and systematizing research, not a divining rod. In that way, clients are less likely to misunderstand the essential role that judgment and intuition must play in any hiring or firing decision. Along those lines, it’s prudent to avoid hard-and-fast “buy” and “sell” rules that can sow confusion about how rigidly hiring and firing decisions are made. One potential way to mechanize this is by using “buffers” that, in effect, give manager researchers the leeway they need to apply judgment in the event, say, a manager badly lags its benchmark and peer group. in us and can execute the long-term strategy in a less-compromising way, without looking over their shoulder. When is manager access overrated? When it’s frittered away on formulaic questions about changes to the manager’s team and portfolio, or to delve into the causes of “tracking error” that have no real bearing on the manager’s perspective or skill. In addition, while it can be useful to place a particular security within the context of the manager’s overall investment approach, it can also be wasteful to burrow into the thesis at a microscopic level, as such details rarely yield any insights into whether the investment is well-founded or not. The deficit in investment management is seldom intellectual, after all; it’s discipline, which a check of a manager’s prepayment assumptions or terminal-year price/earnings multiple won’t shed much light on. Solution: Treat each manager visit like it’s your 3 We overrate the value of manager access. Some clarification is needed here: There is high-quality, useful manager access and then there’s access that serves little discernible purpose. So, what’s the difference? We think that firm culture is important when assessing managers. What we’re trying to understand is what makes the firm tick—why are the managers in the business, what’s their edge, how do they deploy their people and resources to press their advantages, how do they think about allocating capital, and what are the incentives and other tools they use to deliver good outcomes? We need access to make that assessment. Manager access can be useful in a different, less-expected way—it hopefully signals the kind of shareholder we aspire to be. Indeed, one of the ways we can help mitigate career risk is by clearly communicating our expectations to managers and providing a sense of our time horizon when investing. In that way, they’re likelier to feel they have good partners last; ask the “10-year” questions; know what you want to know, upfront. Manager access is unlikely to meaningfully advance the research process if analysts don’t enter the meeting with a sense of dispatch. If your mindset is, “Well, I’ll check up on that in six months when I’m back here,” then it’s no wonder questions devolve to issues of the moment. But what if this was going to be the only opportunity to ask a question in the next 10 years? What would we want to know? Chances are we’d wade deeply into the firm’s process, what differentiates it, and how it will keep its edge going forward—not, “What’s your thesis for Facebook?” It’s also important to define, in advance, what we want to know. True, every manager meeting ought to have a spontaneous, conversational quality, if possible. But that doesn’t preclude manager researchers from game-planning to come up with a list of questions on the issues likeliest to have the strongest bearing on performance through the years. the manager-research system in context, avoid hard-and-fast rules, and educate clients on the “lifecycle” of outperformers. One simple way to avoid getting caught in the trap of managing to clients’ preconceived notions of manager research—i.e., hiring and firing—is to explain the buy and sell discipline upfront. Ideally, illustrate it, perhaps by time-lapsing the portfolio or strategy concerned to show which managers were added or removed from the mix, and the rationale for those decisions. By making the process less abstract, and offering a glimpse of MorningstarAdvisor.com 27 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Contents
Contributors
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012