InvestmentsOct 14 2014

Fund Selector: Making the right selections

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As investors employing a multi-manager approach, we are often asked about what would lead us to be concerned about – or even sack – a fund manager.

Given only a word to describe the most likely reason for terminating a manager, it would be ‘drift’.

One of our main concerns when analysing and monitoring managers does not relate to names entering a portfolio. Rather, what keeps us awake at night is a combination of what is not in a portfolio, or what should not be there.

In other words, managers are often as guilty of buying what they should not buy when it is doing well, as they are of not selling what has not done well after they have bought it. This behaviour, also called the ‘endowment effect’, leads to a very alarming drift in the investment process: ‘thesis drift’.

Behavioural scientists describe the endowment effect, also known as ‘divestiture aversion’, as the hypothesis that people ascribe more value to things merely because they own them.

This is illustrated by the experimental observation that people will tend to pay more to retain something they own than to obtain something owned by someone else – even when there is no cause for attachment, or if the item was obtained only minutes ago.

In the field of investment management, this phenomenon occurs when managers are unwilling to close a position after the market or news flow goes against them, and they instead invent a different or new reason to stick with it

This type of behaviour can also be observed in respect of underweight positions. Take current fund management consensus on Chinese banks, for example.

For the past few years, Chinese banks have been pointed to as the thing not to hold in your portfolio and I can only think of three managers who do not have a large underweight.

Most managers have been very vocal on their reasons for not holding any Chinese banks, citing opaque books, the emergence of a credit bubble, and fears about the implications of the murky and unregulated world of the Chinese shadow banking system.

Some managers have even pledged never to own a Chinese bank stock.

Naturally, having been so vocal about their dislike for the sector, none are keen to be seen as the first one to move in. To borrow an analogy from the animal kingdom, this kind of behaviour is rather like that of Australian sugar ants.

Like most ants, these creatures navigate around their universe by following pheromone trails left behind by others ants. An interesting phenomenon occurs when enough of them lose track of the scent; they begin to follow the ant immediately in front, leading to the formation of a huge ant spiral.

The poor things then become trapped in this spiral, marching pointlessly around in a loop, probably comforted by the false assumption that “someone immediately ahead must know what they are doing”.

The 18th century French author Philippe Destouches, once said “la critique est aisé mais l’art est difficile”.

Roughly translated, this means, “it is easier to be an art critic than an artist”.

Hence, as a fund manager involved in manager selection it is critical for me also to sidestep the traps I hope my managers can avoid.

François Zagamé is a multi-manager at Old Mutual Global Investors