Investors shouldn’t blindly place their faith in a manager and hope to achieve consistent profitable returns. Instead, investors need to do their due diligence and do some digging into the manager’s proposed investment process to see if the offering is worth you placing your trust in them.
With so much choice on offer, investors need to be savvy and understand the strategy a potential investment manager is employing.
Additionally, they should understand which factors create an environment in which that strategy will flourish, and also flounder.
Failing to understand the strategy that your investment manager is employing could lead you to think that their strategy is no longer working after a few bad months.
Instead, it may not be the strategy that is broken but that the recent economic conditions have not been ideal for their chosen method.
The biggest risk with this mindset is that you exit your investment and miss future positive months when conditions turn favourable again.
The potential positive performance could more than cover the losses from those few bad months, leaving you with regret, and diminished funds.
This is particularly relevant when the investment vehicle (fund or otherwise) is new, and therefore doesn’t have a long history of positive performance in different market conditions to provide investors with confidence.
To put this in perspective, there have been times when an investment in Berkshire Hathaway has experienced significant drawdowns.
Obviously, Warren Buffett’s record and reputation as likely the best investor in history provides investors with confidence that there is a very good chance positive investment returns will resume over the long-term.
Those invested at the beginning, however, didn’t have the luxury and their nerves would have been severely tested.
Between 2008 and 2009, investors in Berkshire Hathaway’s B class shares saw their investment depreciate over 50 per cent.
Even those who had been long-term investors would have been forgiven if they started questioning Buffett’s strategy, as a drawdown of that size is hard for anyone to stomach.
But taking the time to understand Buffet’s strategy and the inefficiencies he’s exploited over the years would likely have kept you invested, and those that did this have been truly rewarded, with the value of Buffett’s shares almost doubling from the level it was before the large drawdown.
Of course, asking a manager to reveal their strategy is sometimes harder than getting blood from a stone – understandably, many are hesitant to reveal their intellectual property, but having at least some knowledge of what your manager is trying to achieve, even at a basic level, allows you to identify times when your manager deviates from their strategy.
This should be more worrying to an investor than a period of subpar performance.
When an investment manager deviates from their strategy it suggests that they are no longer confident that they have an edge and don’t believe they can consistently deliver positive performance in the future.
By way of example, Harvest Lane Asset Management deals heavily in the merger arbitrage space. If we were to start buying companies because they looked cheap on a valuation basis, that would be cause for concern.
Knowing your investment managers’ chosen strategy also enables you to set realistic expectations in regard to investment timeframes.
A typical trade in the takeover space averages around four months, but in some instances will take considerably longer. As a result, our volatility of returns has historically been quite low and there are periods of time where our performance will appear stagnant as our positions follow the normal course of progression.
An investor armed with this knowledge would not be surprised to see a few months where our unit price fails to make any meaningful direction.
Instead, a sharp increase in volatility over the long-term average should be cause for further investigation. Again, this should not give rise for an immediate exit, as an increase in volatility could be the cause of multiple takeovers completing at the same time.
This simply reinforces the importance of understanding the strategy through which your capital is being invested.
Let’s face it, taking the time to understand the investment strategy of a manager is not the most exciting task, and many would argue that if you’re paying a professional, you shouldn’t need to do this work yourself.
In reality, flying blind and placing total trust in someone without doing your due diligence rarely pays off.
You wouldn’t think twice about conducting a building inspection before purchasing a property or having a mechanic look over a car you’re about to purchase.
Digging deeper into the strategy of a professional investment manager and consistently reviewing their performance should be mandatory before deciding to hand over investment decisions to a fund manager, broker or financial planner. After all, it is your money.
Luke Cummings is the managing director of Harvest Lane Asset Management.
