How to Choose the Best Investment Manager
Choosing a financial professional to assist in your financial needs and goals is a very important and difficult task. Below we’ve laid out a basic seven step checklist that everyone should be thinking about before committing to a financial advisor or strategy. In short, the goal should be to find a manager that provides customized, individual attention and communication to clients, has a strong track-record of performance, mitigates risk when appropriate, and aligns their incentives with the clients.
Step 1: Understand the various type of investment professionals
Step 2: Determine what kind of investment professional you should be seeking
Step 3: Review the investment professional’s regulatory qualifications
Step 4: Seek a readily accessible investment professional who takes your specific needs into account
Step 5: Review the investment manager’s performance
Step 6: Review the investment manager’s fee structure (i.e. how they charge for their services)
Step 7: Final considerations
Step 1: Understand the various type of investment professionals
Based on the type of key services that are needed, an investor may go to a variety of different financial professionals. Understanding each type of professional’s skill sets is crucial.
The Certified Financial Planner (CFP)
Many people need a comprehensive plan that helps them map out their income and cash sources versus their cash expense, i.e., a budget process. In addition, long term planning may include large future cash needs such as college expenses as well as insurance considerations. All of these issues come under the heading of financial planning and a CFP’s main purpose is this type of financial analysis. Once these basic issues are solved, the investment of liquid assets becomes the next step.
The Financial Advisor (FA)
A Financial Advisor is a rather generic term that can mean many things, but generally speaking, Financial Advisor is the moniker used by many professionals who used to be called ‘Stockbrokers’. Selecting individual securities today is very time consuming and sophisticated. It is why most stockbrokers today have moved towards working together as teams and offering products to clients as opposed to selecting individual stocks that they then sell to each investor, one at a time. It is a dead model out of the 1970’s and earlier. FA’s do some financial planning and more and more try to cover the waterfront of needs to the individual client. Typically, managing the portfolio is out-sourced to a money management arm of the brokerage firm or an independent Registered Investment Advisor. They often have the financial contacts and muscle to find top investment managers to manage their client’s accounts.
The Portfolio Manager (PM)
It is important to understand that a Portfolio Manager is focused on the investment of securities. Portfolio Managers seek to generate strong investment returns while maintaining appropriate levels of risk. All Portfolio Managers are registered with the states or the SEC as Registered Investment Advisors. Mutual Funds, Hedge Funds and individual accounts are all managed by a portfolio manager. Once the basic decision to invest the assets in the market (stocks or bonds) has been made, the Portfolio Manager is the ideal choice as this professional spends all of their time building, reviewing, and optimizing the investment portfolio. Often times, CFPs or FAs are useful in terms of laying out the long-term investment strategy whereas a Portfolio Manager is best to implement it. Bottom Line: Each type of investment professional provides a specific skill set. Although it may be more convenient to have one investment professional cover all of your needs in a ‘holistic’ approach, this professional will be lacking in the services that they do not specialize in.
The key question to first ask yourself is where in your financial planning process are you? If you have just started to think about how to save for retirement, assist with daily household budgeting, insurance needs, what kind of income you might need, or what type of tax-efficient estate planning should be done, then a Certified Financial Planner is probably a logical first step. They will help you build a plan, acquire the right insurance products and set aside some savings that can be used for investment. However, once you have established a basic financial plan, bought the right insurance and set aside a certain level of assets to save for retirement, you need to find an investment professional that specializes in asset investment. This is the primary role of the Portfolio Manager. Hiring a Portfolio Manager is most appropriate for someone who has over $100,000 in assets that they would like to see grow over time. A well-trained Portfolio Manager will take or create your investment account (s) and invest them to achieve an appropriate level of return and risk that is customized for your unique situation. Portfolio Manager’s spend 100% of their time working to maximize this return and risk tradeoff. While CFPs and Financial Advisors often offer this service as well, it is often only a small component of the services they provide. This is not their specialty. Thus, by placing your investments with a Portfolio Manager, you can ensure that you have entrusted your assets to someone who’s entire focus is on making sure that those assets perform well. Bottom Line: If you need to develop a long-term budget (to generate savings), buy insurance, or set-up your estate, work with a CFP. If you have assets that need to be invested, work with a Portfolio Manager. BACK TO TOP
On a very basic level, you want to make sure that your investment adviser is registered with the proper regulatory authorities, has no history of complaints to regulatory authorities, and has the experience necessary to provide useful advice. First, determine whether the investment manager is a Registered Investment Adviser (RIA) or Investment Adviser Representative. RIAs/IARs are investment professionals who have registered with a regulatory entity and may provide investment advice for compensation. They are also required to act as a fiduciary for clients, meaning that the adviser legally must act with the highest standard of care for their clients. You should also review the adviser’s compliance record at FINRA.org, SEC.gov, or your state’s Securities Commissioner to determine if the adviser has investor, company, or regulatory agency complaints. The size of the investment firm will likely be a driver in which regulatory entity they are registered with. It may make sense to also do an internet search on the adviser’s name and their firm. In terms of experience, this is a bit more tricky. Key questions to consider are the manager’s time in the industry, higher educational training (e.g., graduate school) and industry certifications (CFA, CFP, licensing exams – e.g., Series 7, 65). Well qualified investment professionals will typically have a combination of all of these attributes. Bottom Line: This seems obvious, but you want someone that knows what they are doing and has a clean regulatory history. BACK TO TOP
Step 4: Seek a readily accessible investment professional who takes your specific needs into account
Easy access to your investment professional is crucial for several reasons. You want them to fully understand your goals, concerns, and ever-changing financial picture so that they can give you the best advice possible and/or invest a portfolio appropriately. You should feel comfortable reaching out so that any change in your situation can be immediately reflected to the portfolio manager. It also is helpful in that the manager needs to know when you are uncomfortable so they can amend their actions to more appropriately reflect your temperament. A true investment professional will work hard to get a sense for your overall financial picture now and in the future. They should readily understand your current and future needs and desires, but more importantly understand your ability to tolerate risk – both emotionally and financially. In light of an ever-changing financial outlook for many of us, you should look for a manager that maintains communication (at-least yearly) to stay up to date on how your financial picture may have changed. Further, investment professionals should remain accessible to clients via phone or email. Along these lines, a good investment manager will work with new clients to understand them and then seek to implement an investment strategy which mirrors your financial dynamic. You should look for a manager who customizes investments around you, not a manager who attempts to fit you into one of their mass produced investment products. A key indicator along these lines is often the types of investments that an investment professional attempts to place their clients in. Investment professionals that tend to follow along ‘cookie-cutter’ strategies often place clients in a swath of mutual funds or exchange-traded funds (ETFs), rarely changing allocations and never customizing individual investments. The negative here is that these strategies are rarely altered to account for changes in your financial circumstances or to account for a rapidly changing market outlook and the securities within these funds aren’t tailored to your needs. Wouldn’t it be smart to sell some securities before the market may crash? Additionally, the fees can be quite high as the mutual funds (and even the ETFs) charge high fees on top of the investment professional’s fees. You end up paying double fees. Bottom Line: If an investment professional isn’t willing to communicate with you and accurately translate your personal needs, it is unlikely they have adequately customized your investments to create an optimal portfolio. BACK TO TOP
In many ways, this is the key question. Have the investment professional’s clients prospered under his/her guidance or suffered? When interviewing managers who will be investing or advising on asset investment, you should always ask for performance data (usually, at least 5-years worth). If they do not provide performance data or will not provide performance data, you can be sure that it is not because they have done an outstanding job for their clients, but are too shy to reveal it. In reviewing performance, you should be very careful about what you are looking for. Do not focus on absolute returns. A successful manager is the manager who is able to outperform their appropriate benchmark. This is because investment professionals are charged with investing assets in the market which can have an enormous impact on their returns regardless of whether they are picking the right stocks or investing in the right sectors. For example, if the benchmark (e.g., the stock market) is down 20% and an investment professional’s portfolio is down only 10%, the professional performed well and should be congratulated. Conversely, if the stock market is up 30% and the professional is only up 20%, the investment portfolio performed poorly. The one caveat is that performance also needs to be taken in the context of risk as some clients request under-performance on the upside in order to achieve outperformance when the market falls. Additionally, investment return data should be provided according to Global Investment Performance Standards (GIPS ®). Besides return data, potential investors should look closely at the type of risk that the investment professional seems to take on. You should not just be looking to the manager who has the highest returns. Instead, you should be looking for a manager who generates high returns while taking on a modest or manageable level of risk. There are several basic ways to get a sense for a manager’s risk level without doing detailed calculations. 1). How did the manager do during big down years? In particular, 2008 may be telling if the manager significantly underperformed the market. This helps investors gauge how the manager deals with a disaster scenario. 2) How volatile is the return data? If the manager goes up 60% in one year, then down 20%, for example, it is likely that the manager is taking on a lot of risk. 3) How diversified are the manager’s portfolios? For a stock portion of the portfolio, this can be determined on several levels, but the easiest, most basic way would be to count the number of individual stock positions (usually 25-35 stocks is fairly well diversified) and the number of sectors (there are 10 total) that are covered by those stock positions. Finally, make sure there aren’t any positions that are egregiously large (e.g., +10% of the portfolio). The size and number of positions can often be telling about whether a manager has performed well through a sustainable process or whether they relied on a few very large bets that happened to be right. Finally, beware of any manager who promises a rate of return or performance level. Investing in the market involves taking on a certain level of risk, and no investor can realistically guarantee a certain level of return. Bottom Line: Always demand to see investment performance from an investment professional who wants to manage your assets. When interpreting this performance look at relative performance and attempt to determine how much risk was taken on to achieve those results. BACK TO TOP
There are several wrinkles to consider when evaluating a manager’s fees. Investors often decide between managers based on fee differentials. However, this is often the classic penny-wise, pound-foolish mistake that clients make in choosing a manager. The best, most-talented managers tend to have higher fees. Managers with especially low fees should be viewed somewhat skeptically. What services are they not providing? What skill-set do they not possess? That said, egregiously high fees don’t make sense either. Besides determining the size of the overall fees, you should look for how the fees are charged.
Management fees are the fees that an investment manager will charge for the service of managing the account. For long-only (i.e., not hedge funds) investment management, fees (before commissions) should be roughly in the 0.75%-2.00% range. Usually, these fees are based on the amount of assets that are under management, but this is not always the case (see Basis for Charging Fees below).
Trading commissions are the expenses that broker-dealers are paid to execute trades. The investment manager typically does not receive any of these commission dollars.
Beware of hidden fees. For example, many managers use mutual funds, all of which charge the fund fees for management as well as printing reports, paying board members, etc. Unfortunately, the mutual fund fees are not readily apparent because they are taken straight out of the fund’s net asset value. Further, ‘load’ fees to open or close mutual funds can be egregious (1.00-8.00% of the account’s value). Avoid loads at all costs.
Custody fees are fees that the custodian (e.g., U.S. Bank) charges for record-keeping and to simply hold the assets. These fees are typically low (e.g., 0.05%), subject to minimums. Even though they are the client’s expense, some managers choose to pay this fee themselves and simply charge a slightly higher management fee to account for the difference. Note, some brokerage houses don’t charge custody fees, but force clients to trade with them to cover the custody costs.
Performance fees are associated with hedge funds and represent fees that investment managers may earn based on the profits generated for the account. These fees are often very high (typically 20% of profits) and significantly cut in to investors upside potential. Recently, this fee structure has come under scrutiny as many of the hedge funds have underperformed their benchmarks.
Basis for charging fees
This is critical because it gets behind the core incentives for the manager. If a manager is paid based on trading volume, the manager clearly has an incentive to trade more often which racks up higher commissions for the client to pay and is likely less tax efficient. There also may be an incentive for a manager to provide service to larger clients first if the account is non-discretionary. Instead, you should look for an investment manager who charges his fee based on the amount of assets that they manage. In this way, the manager earns higher fees when the account grows larger. Both the manager’s and client’s incentives are thus perfectly aligned.
Wrap accounts are often opened through a brokerage house and charge a fee (typically 1.50-2.00%) which “wraps” all expenses (Mgmt fees, custody fees, and commissions) into one. If you are opening a wrap account with a broker you should expect a Wrap fee to be a little higher for this reason. Bottom Line: Fees are important, but shouldn’t be the most important metric. Lower fees do not equal better long-term performance. Would you hire a doctor simply because they charged the least amount of fees? When you are talking about your long-term financial future, quality is crucial. BACK TO TOP
Besides the steps laid out above, there are a few final checks to go through before determining the right manager for you. Should you obtain references? References can be useful, but realize that no manager is going to provide a bad reference. Use more quantifiable metrics like (investment performance, experience level, fee structure) and your general intuition about a manager’s accessibility and style to determine whether you would like to work together. Is the professional with a large firm or a small firm? Frankly, many investors specifically seek to work with larger investment firms simply because they are larger. They feel safer with these large institutions. Ultimately, this is erroneous. Your investments are going to be managed by one manager, one person. The results will be a direct result of this person’s competence, not whether or not their firm employs 100,000 people. Ironically, many investment studies published for the institutional market have shown that there may actually be an advantage to working with a smaller manager. Smaller managers have been shown to outperform managers with large assets under management (AUM). The logic is that manager’s with huge AUM are unable to invest in many smaller companies because they are simply too large and there is not enough liquidity. Unfortunately, small companies are where many of the biggest market inefficiencies exist and provide some of the best opportunities for investment performance. Do I need a contract? All investment relationships should be documented via an investment advisory agreement which lays out the commitments by both the client and investment professional Bottom Line: Choose the investment professional who you feel comfortable with who meets the criteria laid out above – not based on where they work or whether they provide dazzling references.
To sum up the above advice, you should be looking for an investment professional who….
- Has the appropriate experience, training, and regulatory clearance
- Is willing to understand and readily communicate with you about your financial needs and risk tolerances
- Creates a customized investment portfolio geared toward your individual needs
- Has a strong track record of investment performance without taking on too much risk
- Has a fee structure that is at a reasonable level and matches the manager’s incentives with the clients
Picking an investment manager is very important decision that should not be taken lightly. Oftentimes, it can be the difference between a successful financial future and one of high-stress and lifestyle cutbacks. We wish you luck in your search.