Income Investor Perspectives

• When should an investor use a professional manager?
• If an investor needs more performance (yield or return), should he/she use a professional manager?
• Should a manager be selected based on performance?
• If a manager’s performance is lagging, should they be fired (or sold) by the investor?
• Will using a professional manager protect from market declines?

Professional managers need to be students of the market.

SUMMARY: Because so many investors seem to select managers by chasing recent performance, one might imagine that professional managers market themselves only by touting their performance. However, the fundamental reasons to use a professional investment manager are when the investor does not have the time or the necessary expertise to properly make those decisions themselves. Professional managers can be employed for all or a portion of a portfolio and should be selected first based on how well the manager’s strategy fits in with the investor’s goals. Neither performance nor fees should be the primary criteria for manager selection—downplaying the importance of how the strategy fits into the long-term goals could easily lead to improperly balanced risk exposure. While performance is very important, investors should favor those managers who emphasize their process, and be wary of those touting only their recent performance. 

Given how the bond markets have evolved, with declining liquidity and changes in economic and credit conditions, experienced investors especially must carefully examine their own abilities to take these risks into account in their decision making process, and consider if it is now more appropriate to delegate some or all of those decisions to a professional manager.

This article discusses the benefits of using a professional manager to manage some or even all of the investment decisions—for example by using mutual funds, ETFs or a separately managed account (SMA). Beyond the scope of this article is a discussion of using a professional wealth manager—such as a registered investment advisor—to conduct financial planning and to make all of the allocation and investment decisions.

Planning First

Selection of a manager—just like selection of an individual security—is a part of the portfolio implementation process, which should be subsequent to the investment planning (and goal setting) process.

Prior to retirement, all investors generally have the same goal: save, invest and earn as much as possible. While this is an oversimplification, it provides some insight into why most investors in the accumulation phase of their investment lives don’t see a financial plan as a necessity. However, with the approach of retirement and the end of accumulation—the needs of each investor then become very specific based on age, amount saved, other sources of income, spouse, children, cost of living, desired legacy provisions and a myriad of other factors.

“For most individuals, there will be a point in time when there is no longer additional cash being added to the portfolio. Individuals, especially those retired, don’t have the luxury of receiving additional contributions, and preservation of principal is paramount to their investment strategies.”  (Trone, Albright and Taylor, The Management of Investment Decisions, page 297.)

As the transition to retirement becomes imminent, it becomes increasingly important for most investors to have a personalized plan to estimate the likelihood of their ability to maintain their desired lifestyle in the years in which they will need to rely on their investment income (and perhaps their principal) for their spending needs.

Depending on their needs, some retirees will have more than sufficient principal accumulated to be comfortable in their ability to fund their retirement years—a plan is less crucial for those investors, but can still provide a helpful guideline for the portfolio implementation decisions.

Based on the investor’s objectives—as defined by the plan—which asset classes have the appropriate characteristics? How much should be allocated to each asset class? Then, based on the asset allocation and the market outlook, which sectors and/or securities are most appropriate? The selection of individual investments can be done by the investor, or delegated to a professional manager.

When Should An Investor Consider Hiring A Professional Manager?

The fundamental determinants of whether or not to hire a manager are the cost involved and the degree to which the investor is qualified to be (or wants to be) involved in the portfolio management decisions.

An investor may wish to consider using professional management when costs are lower than the value of the investor’s own time. (Including the opportunity cost of devoting the appropriate amount of time and effort to prudently managing the portfolio. Time spent monitoring the portfolio is time that cannot be spent working, traveling, reading, golfing, volunteering, etc.)

Even with sufficient time and desire, however, how does the investor determine how much expertise they need to have to be able to prudently manage their own investments? With higher risk/higher return segments of the portfolio, greater attention and experience will be needed. Some investments carry less risk and are easier to understand and navigate, while other markets may be higher risk, less liquid or opaque. Investors should also be mindful of how the markets themselves have changed over the course of the last several years—markets for securities that may formerly have been deep and liquid may be much less so in the current market and business environment. For example, even though the bond markets appear to trade similarly today to how they have in the past, it can be more difficult to buy and sell now than it has been in the past, due to the dealer community devoting less capital to the bond markets. This is especially noticeable in challenging market conditions.

Don’t Chase Performance

One might imagine that professional managers market themselves only by touting their performance, because so many investors seem to select managers by chasing recent performance.

Of course it can be very tempting to select a manager (or a managed product, such as a mutual fund, ETF or Separately Managed Account) based on performance. Market performance and investment performance are headlined everywhere, and it’s easy to compare performance numbers. It can be hard to commit to a more appropriate strategy when it means forgoing another (but less appropriate) product with higher historical returns.

There is no one-size-fits all answer about which manager or strategy to use, but the more exotic or less liquid an investment or strategy, the greater the potential benefit of using professional management—even for the investor who may have the time and interest in being self-directed, because the value added by a professional manager is their process—their familiarity with the specific investments or markets and diligence in making and monitoring those investments to make rational buy/hold/sell decisions.

Selecting and monitoring managers should be done with the same care and effort as selecting and monitoring individual investments.

A well-defined and rational investment process—whether self-directed or employed by a professional manager—is crucial to invest successfully. As noted by Ben Graham in his still-in-print classic from 1949, The Intelligent Investor, “What’s needed is a sound framework for making decisions and the ability to keep emotions from corroding that framework. You must supply the emotional discipline.” [Emphasis added.]   Beware though, that while hiring a professional manager may remove some of the temptation to give in to emotional decision-making, some investors have been known to “trade” managers as they would individual stocks—hiring and firing them as their performance waxes and wanes. A level of activity that could be imprudent if done with individual stocks or bonds.

Keep in mind—past performance is not a prediction of future returns. Hence the importance of focusing on process and selecting managers based first on how the strategy (for example, equity income) fits into the investor’s long-term plan and then based on the managers process, costs and performance.

In practical terms, it is not uncommon for some investors to retain control for a portion of their portfolio and delegate decisions for the rest. Some examples:

• A seasoned and experienced investor who maintains control of his portfolio of high quality individual municipal bonds while using professionally managed solutions for the equity, international and high-yield bond allocations.
• An investor with significant stock market experience chooses to manage some of her equity investments using individual stocks in addition to ETFs for her core market exposure, while using a separately managed account for her municipal bonds and an open-end mutual fund for her high yield bond allocation.
• Self-directing a CD ladder to manage exposure to the FDIC insurance limitation while using a mix of funds for the balance of the portfolio.

The challenge, of course, is how can you evaluate the manager’s process, much less compare between two or more managers? It is easy to compare performance and costs (fees), so it is understandable that many investors would use those as criteria when deciding whether or not to hire a manger, or which manager to use. While performance and fees are important data points to be considered, performance is the by-product of the market environment, the manager’s decision-making process and the fees charged.

There is insufficient space here to provide an exhaustive guideline to evaluating managers, but here are a few key points that investors may wish to keep in mind. (Most wealth management firms have professionally staffed departments whose full-time job is to examine and monitor the approach and the results of the professional managers they accept onto their product-offering platform.)

The Investment Process

Professionals who invest on behalf of others are held to a high standard—they are considered fiduciaries and have a legal obligation to act first and foremost in the best interests of the client or beneficiary.   Each manager will have their own approach to making decisions. In general, a professional manager is seeking to manage risk exposure—not to eliminate risks, but to mitigate some risks, while using other risks to seek incremental return. The manager’s investment process seeks to evaluate the potential reward associated with foreseeable risks—“buying” some (overweighting) and “selling” or hedging others (underweighting).

A short list of some of the potential factors to be accounted for in the investment process is below. Factors that are potentially relevant in one asset class may be less relevant or even irrelevant in another. In addition, depending on market conditions, the weight given to a particular factor may be moved higher or lower.

• Current and expected interest rates
• Inflation
• Economic conditions
• Credit trends (perceived by the market, as well as ratings agencies and internal opinions)
• Equity market action
• Bond market action
• Market supply and demand, liquidity and seasonal variations
• Interest rate risk
• Reinvestment risk
• Call (or early redemption risk)
• Extension risk
• Credit risk
• Equity risk (bankruptcy)
• Concentration risks, such as geographic, sector, asset, etc.
• Risk of change in tax treatment
• Legal or regulatory risk
• Structure of security (for example, bonds with low or very high coupons that may have limited acceptance in the market)
• Foreign currency exchange risk
• Risks specific to the manager, such as personnel (experience, tenure, turnover, etc.), operational risks, asset size and growth, profitability and track record, complexity of their strategy, etc.

In Conclusion

Will using a professional manager protect from market declines?

Professional managers generally offer investors a significant advantage in expertise and resources. While many investors may feel comfortable being self-directed in some or all of their investment activities, they should carefully compare their own decision-making process against the costs and potential benefits available from professional managers to decide if their long-term goals may be better served by full-time professional investment supervision.

The fundamental reasons to use a professional manager to handle investment decisions are when the investor does not have the time or the necessary expertise to properly make those decisions themselves. Professional managers can be employed for all or a portion of a portfolio and should be selected first based on how well the manager’s strategy fits in with the investor’s goals. Neither performance nor fees should be the primary criteria for manager selection—downplaying the importance of how the strategy fits into the long-term goals could easily lead to improperly balanced risk exposure. While performance is very important, investors should favor those managers who emphasize their process, and be wary of those touting only their recent performance.

The Benefits of Professional Management.

Income Investor Perspectives

Timely insights for advisors and their clients.

December 18, 2014. Updated May 17, 2015.

The information contained herein is based on sources believed to be reliable, but its accuracy is not guaranteed. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

©2015 Patrick F. Luby

All Rights Reserved.