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Selecting Fund Managers; What you need to know

We believe that identifying truly skilled managers who will beat their benchmarks is highly labor intensive and requires a great deal of skill, experience and judgment. We further acknowledge that the average active manager will underperform his or her benchmark as a result of expenses and transaction costs. However, using active managers does not require that we use all active managers, or that we use the average active manager. We only have to be able to identify a small number of skilled managers in order to add value. We can set a very high bar where if we can’t identify a manager in whom we have high confidence in their ability to outperform a benchmark going forward, we can instead use an index or index alternative. The due diligence approach we employ in selecting managers is based on this very high hurdle. We are seeking to identify not only skill, but also whether there are areas of uncertainty that have the potential to erode our confidence. Our goal is to own only those managers where our confidence is very high and the uncertainties are very low.

Our fund research process begins with performance screens to identify funds that may be worthy of further research. By itself, past performance has no predictive value, and therefore significant additional work is required to identify managers likely to outperform in the future. Our process involves identifying why a fund performed well in the past, determining if the portfolio management team has an identifiable edge that contributed to that outperformance (i.e., are we confident the past performance was the result of skill rather than luck) and assessing whether the edge (if one exists) is sustainable. To answer these questions requires intensive firsthand contact with fund managers and their research teams. The following article outlines our six-step process of selecting mutual fund managers.

Step One: Performance Screens. Performance screens and quantitative analysis are a starting point in our research process. We consider funds that have outperformed their peer group and benchmarks over a reasonably long period of time (generally five years or more). Occasionally we will consider funds with a shorter record. We have created our own proprietary database of manager returns that enables us to incorporate separate account and mutual fund track records, and we are willing to take those into account if we believe it is representative of how the existing fund would have performed over the same time period. In addition to absolute performance we take into account:

Performance consistency, volatility and downside risk relative to the fund's peer group and benchmarks over a wide variety of time periods (which we can adjust in our database)
Special factors that impacted performance that may not be repeatable, such as a very large contribution to longer-term outperformance from a single year or from just one or two "home run" stocks
The level of assets on which the record was based, as it's a possible red flag if assets are now much larger and the performance was generated with a tiny asset base and/or by investing in small companies
Our expense thresholds of 1.2% for larger-cap funds and 1.5% for international and smaller-cap funds. However, we will make an exception for a new fund with a small asset base if the expense ratio will fall below our threshold as assets increase.

Step Two: Due Diligence Questionnaire and Document Review. If a fund passes our performance screens and looks promising on a quantitative basis, the next step is for the fund management firm to complete our detailed due diligence questionnaire. Their answers will start to build our understanding of their investment approach and management practices. Our questions delve into the firm’s investment philosophy and process, portfolio management and risk control policies, team members and roles, their compensation practices and incentives, and growth plans. We also read all of the fund’s shareholder reports and manager commentaries going back a number of years, as well as any media articles and interviews that may give us additional insights into their thinking and decision making process.

Step Three: Initial Portfolio Manager Interview. After reviewing the responses to our questionnaire we formulate more detailed follow-up questions, and conduct a phone interview with the portfolio manager(s). This is an important part of the process in which we begin to qualitatively assess the manager’s discipline and skill. We ask for specific examples as we attempt to verify that the manager’s actual practices are in line with how the investment process is articulated in the questionnaire and other documents, and to understand aspects of his/her approach that may not come through clearly from the questionnaire. We want to understand the reasoning behind the manager’s investment philosophy and process, how it has evolved, their degree of intellectual honesty and willingness to admit mistakes, how hard they work, what they expect from their team, and how competitive and driven they are. We also conduct phone calls with members of the analyst team to assess their quality and contribution to the process.

Often, after this initial phone contact, we eliminate the manager from further consideration despite their strong historical performance, due to qualitative red flags. For example, we may find the manager to be an "empire-builder" who is more focused on growing the firm than on the stock picking work that earned his/her growth in the first place. Such individuals can be overconfident, with a tendency to rationalize excessive asset growth, or can spread themselves too thin with non-stock-picking responsibilities. Or we may not be able to get comfortable with the managers’ philosophy or research process, and be unable to see clearly how their past success can be repeated and sustained. We don’t pretend to have all the answers, and a great manager may have a process that we can’t fully get our hands around. We know we won’t be able to identify every great manager, but we also know that is not a requirement for us to succeed.

If after the initial interviews we have built a strong confidence in the manager’s investment process, discipline in executing that process, and plans for managing growth, we will normally schedule a visit to their offices for on-site due diligence.

Step Four: The Site Visit. Our objectives of the site visit are to spend time face-to-face with the manager(s) and also visit with the analyst team and other key investment team members, e.g., traders. We will try to assess the following in more detail:

Determine if there is consistency between the way the manager describes his/her investment process and the stocks they actually own. We want to know if the way that each stock was researched and the justification for the buy decision are in line with the investment philosophy, so we grill the manager about stocks in the portfolio. We do the same thing to assess their sell discipline, discussing stocks that have been sold and the reasons why. If we find major inconsistencies this might tell us that the manager is not disciplined in executing the strategy or that the description of their investment process includes aspects that are more marketing spin than substance. Either one is a big negative.
Determine if there is consistency among all team members. By talking to members of the analyst team, we can see if everyone is on the same page and gain further clues as to whether the process is executed as described.
Evaluate the quality of the team. We evaluate how smart, driven, focused, passionate, experienced, humble, confident, performance-oriented, etc., the analysts are.
Evaluate the culture and compensation incentive systems. We want to assess whether the team is likely to stick together. We believe stability is critical to the ability of an investment organization to stay focused, so we look for firms that have healthy work environments and where everyone is passionate about what they are doing. If there has been personnel turnover in the past, we do everything we can to understand the reasons behind it.
Understand management’s vision for their business. We want to know how they see the firm changing over time, how the team might change, what other products they might launch, how big they want to get, etc. We understand that all businesses want to grow, but we want to see the desire for growth balanced against a clear understanding of the firm’s fiduciary responsibility to its current shareholders.


Step Five: Final Follow-up and Third-Party Contacts. After we digest the information acquired during the site visit, there are usually some additional questions that require follow-up by phone or email. If there are further questions or issues that can’t be resolved from talking to the manager, we will use our extensive industry contacts to do more detective work. Sometimes we know people in the industry who worked with key members of the team at another job or who previously worked at the firm we are researching. At times these contacts are invaluable. We also check firm references (e.g., clients, Wall Street brokers) in situations when we think it will add value.

Step Six: Litman Gregory Research Team Vetting. Finally, the lead analyst responsible for covering the fund presents his analysis and opinion at a Litman Gregory research team meeting. (We should note that the team has many informal conversations and meetings discussing the funds we are working on prior to the more formal final meeting). If the analyst thinks the fund is worthy of recommendation, which signifies confidence that it will beat a benchmark going forward, he or she must convince the rest of the team. We have lively discussions and debates, with other members of the team playing the role of devil’s advocate, challenging the lead analyst to support or expand on certain points. This meeting typically lasts several hours, and in many cases it generates a few additional questions/issues for the analyst to follow up on before a final decision is made. The research team meeting is an important final step in our investment discipline. The analyst knows he/she will have to present their case before the entire research team and that people will be on the lookout for any analytical errors, biases or shortcuts in research. Consequently, it is important to be very thorough in the research and analysis prior to the meeting.

Ongoing Monitoring: If a fund makes it onto our Recommended List we continue to monitor it closely, and we will continue to do so for as long as the fund remains recommended. The most important aspect of our monitoring process is a regularly scheduled "fund update" phone interview with the fund’s manager. In these calls we cover significant developments and changes in the portfolio, the team, the firm, etc., and we continue to test our original thesis for recommending the manager. We have in-depth discussions of stocks they have recently bought and/or sold in order to assess whether or not they are sticking to their investment discipline. We also use these interviews as an opportunity to gain further insight into their asset class. Our typical fund update cycle is every six to eight months and the phone interviews typically last 60 to 90 minutes. However, any time there is a significant event, such as the departure of a team member or the addition of a co-portfolio manager, we will contact the manager immediately to follow up. In addition, when fund managers and analysts are in the San Francisco Bay Area they often come by our offices to meet with the research team. What are we looking for in this time-consuming and labor-intensive process? Simply stated, we are looking for managers with an identifiable edge that we are highly confident can be maintained. Click here for examples of what makes a good stock picker.

The Importance of our Discipline
Just as we demand a clear investment discipline in the managers we recommend, it’s vital that we maintain our own discipline and very high standards. Going through all these steps doesn’t guarantee success. Critically important to preventing mistakes is our acceptance that not many managers will make the cut. This doesn’t bother us because we don’t need to identify very many great managers. We only need a few. And the reality is there are not that many highly skilled stock pickers out there that have an identifiable edge who we believe will also maintain their focus, team stability and grow their business with shareholders in mind (as opposed to maximizing their own bottom line). So though it is frustrating to spend 30 to 60 hours (or more) investigating a fund company only to decide that they don’t make the cut, maintaining a very high standard reduces mistakes. So we pass on fund companies if we don’t get all the information we need, if our conviction level is not extremely high, if we are not sure if the firm is being straightforward or if we have significant doubts about any of the above keys to success.

The benefits of all this work go beyond significantly increasing our batting average when it comes to fund/manager selection. In addition, it allows us to be patient with managers who go through a slump, as they all do eventually. If one our recommended funds starts underperforming, we circle back, try to understand what is going on and assess if something significant has changed with the team or process or if we missed something in our initial analysis. If none of the reasons for initially recommending the fund have changed, then we have the confidence (based on our exhaustive upfront research) to stick with a manager who is underperforming for a while, or whose style of investing is temporarily out of favor.

Investors want quick answers. Some quick answers are arrived at by projecting a track record forward without any additional thought. For those who realize the flaws in this approach, buying the whole market at the lowest possible cost (indexing) provides another quick answer. Doing high quality due diligence on stock pickers and fund companies requires a disciplined, exhaustively thorough effort—it is not a quick answer. It is highly labor intensive. But we believe that in doing the hard work that no one else wants to do, we can continue to add value by finding managers who will be able to beat market benchmarks over the long term. And as is true throughout investing, a small edge adds up to big rewards over time.

Statistics show that the initial success for new forex traders is disturbingly low. Over time, this trend tends to improve, but for many, it is too late. After posting a series of losses, many new traders will give-up, believing that forex trading is simply not for them. It does not have to be this way.
Lack of Experience

Forex trading - like any new initiative - has a learning curve. However, unlike learning a new skill such as learning to play guitar for instance, you are not risking your entire savings while discovering the difference between a major and minor chord. Learning about the currency markets and basic trading principles solely on a trial and error basis is not a recommended approach for gaining the skills necessary to be a successful forex trader.

Most online forex brokers offer a practice version of their trading platform that offers the very same experience as a live trading application. Typically, once you create a practice account, you are free to trade and deal as you wish risking only the "play" money used to seed your account.

With a forex demo account, you can see how the market reacts to economic forces including news events without actually risking your investment capital. However, you must treat this account seriously if you expect to learn from the experience. If you simply shrug off a loss without understanding why the loss occurred, then you are wasting your time and setting yourself up for disappointment. Take advantage of this unique forex market training tool before committing your money to a real forex trading account.

Unreasonable Expectations

First off, stop believing all the “get-rich quick” hype still perpetrated by some forex dealers. Yes, there are those that do get rich trading forex but some people also get rich selling houses. In either case, it does not happen overnight and it might take years to gain the experience and insight to turn forex trading into a full-time, successful occupation.

As a new forex trader, if you manage to stay in the game without losing all your money in the first few months as is all-too-common – then you may be able to learn what is required to be profitable. In other words, don’t quit your day job just yet.

Absence of a Sound Trading Plan

Next to having unreasonable expectations with regards to the risks associated with forex trading and the amount of time required to be successful, a common mistake made by new traders is the lack of a forex trading plan. In reality, there are two aspects to this plan; an overall objective for your trading activities and a plan for each trade you make.

Your overall objective should include the currencies that you intend to deal in, the amount of leverage you will use, and the amount of time you intend to devote to your trading activities. Your plan must also include a realistic rate of return you expect to achieve. In addition to your overall objectives plan, you also need an exit strategy plan for each trade you make that includes the upper and lower boundaries of the trade.

In other words, you must identify the level at which you will close positions and take your profits (take-profit order) or in the case of a losing trade, the level at which you are prepared to go before you get out of the trade thus limiting your losses (limit order). We’ll talk more about stop-loss and take-profit instructions later.

Lack of Discipline

A plan is only of value if you actually have the patience and the discipline to follow it. While this can be difficult, it is necessary if you expect to be successful, and it is this very reason why developing a plan prior to the trade is so fundamental. As rates fluctuate, you can easily get caught up in the market and it is only human nature that you will begin to second-guess your actions. If, for instance, the rate moves up surpassing your original take profit point, you may be tempted to hold out for an even higher return; alternatively, if the price drops below your limit level but you believe there is a big rebound just around the corner, you may be tempted to keep the order open on the hopes of a reversal.

But does either scenario really make sense? If before you entered the trade you had a sound reason for establishing both your take profit and your loss limit levels, how likely is it that conditions have changed so much that now you are prepared to throw your previous assessments out the window in the heat of the battle? Can you be sure that you are not acting on emotion rather than sound analysis?

This is why a plan is so important – it allows you to avoid the emotion that is bound to arise during times of volatility.

Now this is not to say that a trading plan can never be revised – in fact, your overall objectives should be re-examined every few months or even more frequently if required. As well, it may be necessary sometimes to abandon a plan mid-trade if market conditions warrant but this should be the exception and not the norm.

And yes, sometimes the market can be so volatile that no amount of planning will produce positive results. In this case, maybe the best option is simply not to trade until you can get a better handle on things. Never allow yourself to fall into the “I have to do something” trap – sometimes the best plan is to do nothing.

Failure to Include Stop-Loss and Take Profit Instructions

When you place a market order and leave it open – that is, enter a trade at the market price without instructions to close the order – you are in effect, gambling with the total value of your account. For this reason, you should consider adding stop-loss instructions to all open positions.

For instance, if you are holding a long GBP/USD position, you can include a stop-loss instruction that automatically sells your long position if the rate falls to a certain level. In this way, you can limit the amount that you could lose on any given trade – even if you are unable to constantly monitor your account.

Take-profit orders are similar in that they allow you to establish the rate at which you want open positions closed in order to lock-in profits. Again, you simply need to identify the rate at which to take the profits, and the trading system closes the position without further intervention on your part.

Excessive Leverage

Depending on your experience level, trade leverage can be a powerful tool to help you maximize returns, or it can be the cause of your downfall. It is not something to be taken lightly and if you do not understand how it works, don’t trade until you do understand.

Holding Too Many Open Trades

Fighter pilots call it “helmet fire” and it happens when too much is happening around you too quickly for you to react. In the cockpit of a jet fighter, it can get you killed – as a forex trader, you may not end up dead but you will probably end up broke.

Holding Losing Positions Too Long

One of the things that really separates seasoned forex traders from those just starting out is their ability to determine when a losing trade is not going to reverse the trend. Rather than “hold and hope”, disciplined traders will take the loss and get out much more quickly.

This is another reason to set protective stops on all your trades; if you include effective stops when you submit a new trade, you can at least limit your losses without having to spend too much time “babysitting” the order. If the trade hits the stop, you will lose the amount committed but you also protect the bulk of your capital, leaving you with funds to move into something else that, hopefully, will be more profitable.

Sometimes, you just have to treat these things as life lessons – learn and move on.

Ignoring Rate Spread Fluctuations and the Impact Spreads Have on Profitability

Exchange rate spreads – the difference between the bid and the ask price – are of utmost importance and directly affect the profitability of each trade. You need to be aware that spread differentials can fluctuate wildly during the day – sometimes to the point of turning a profitable trade into a losing one.

You also need to understand that forex spreads will widen during off-market hours when volumes and liquidity are lower. In addition, spreads tend to widen ahead of important news such as an impending interest rate decision or the latest employment results.

Thinking About the “Big Win” More Than Effective Cash Management (AKA Greed)

This one is pretty straight-forward – greed; or more correctly, how greed can cause you to enter into ridiculous trades. This must be the same gene that causes some people to keep “doubling-down” even when the odds are so against them that it make no sense at all. If you want to gamble, go to Vegas.

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Forex has caused large losses to many inexperienced and undisciplined traders over the years. You need not be one of the losers. Here are twenty forex trading tips that you can use to avoid disasters and maximize your potential in the currency exchange market.
1. Know yourself. Define your risk tolerance carefully. Understand your needs.


2. Plan your goals. Stick to your plan.


3. Choose your broker carefully.


4. Pick your account type, and leverage ratio in accordance with your needs and expectations.


5. Begin with small sums, increase the size of your account through organic gains, not by greater deposits.


6. Focus on a single currency pair, expand as you better your skills.


7. Do what you understand.


8. Do not add to a losing position.


9. Restrain your emotions.


10. Take notes. Study your success and failure.


11. Automate your trading as much as possible.


12. Do not rely on forex robots, wonder methods, and other snake oil products.


13. Keep it simple. Both your trade plans and analysis should be easily understood and explained.



14. Don’t go against the markets, unless you have enough patience and financial resilience to stick to a long term plan.



15. Understand that forex is about probabilities.


16. Be humble and patient. Do not fight the markets.


17. Share your experiences. Follow your own judgment.


18. Study money management.


19. Study the markets, fundamentals, and technical factors leading the price action.


20. Don’t give up.

Finally, provided that you risk only what you can afford to lose, persistence, and a determination to succeed are great advantages. It is highly unlikely that you will become a trading genius overnight, so it is only sensible to await the ripening of your skills, and the development of your talents before giving up. As long as the learning process is painless, as long as the amounts that you risk do not derail your plans about the future and your life in general, the pains of the learning process will be harmless.

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