Gary D. Halbert President & CEO

Smart Money magazine ran an article in its October 2002 issue entitled “Ten Things Your Money Manager Won't Tell You.”   This article has been widely mentioned and quoted in financial circles and especially on the Internet.  This month, I will discuss the high points of the Smart Money article, but would first warn you that there are a lot more than 10 things that a professional money manager may not tell you.

It is a mistake to assume that any money manager or mutual fund will voluntarily hand you all of their pertinent information on a silver platter, especially if some of that information is negative.

You have to know how to dig for the pertinent information, how to ask the right questions and press until you get the real answers.  This is a daunting challenge for most investors, but in this issue, I will arm you with the information and tactics you need to get the full story on any professional money manager or mutual fund you may consider in the future. 

This is a special issue of Professional Investing that you will want to keep in your “permanent file” as the information and tips that follow will be useful for you today and for the future.  Because this information is so valuable, I am pulling my copyright protection on this issue, so that you may photocopy and share it with friends, relatives and whoever you think appropriate.

Read on, learn and then put this information to good use.

Introduction

At times, interviewing money managers is like giving your teenage kids the third degree after they stayed out until 3:00 in the morning.  They won't necessarily lie to you, but you have to ask the right questions to get the whole truth.  At ProFutures, we have made a business out of asking the tough questions and getting the answers from money managers.   In this issue, I will review the high points of the latest Smart Money article, but also share with you some other points we feel are equally, if not more, important. 

Before discussing the items in the article, it is important to note that Smart Money wrote this story encompassing mutual fund managers, managed account Advisors, and hedge fund managers.  I should point out, however, that not all of the negatives brought out in the article apply to all of these different kinds of managers.  Iwill point this out as we go along.

Analysis of the Smart Money Article

The primary point made in the Smart Money article, and the one that was so widely quoted, was that many mutual fund managers today have a relatively short tenure in the business.  That news should not be shocking to experienced investors, since the period of time between 1991 and 1999 saw literally thousands of new mutual funds created.  There is no way there were enough seasoned professional money managers to go around.  Therefore, the fund companies picked some of their brightest up-and-comers, hit them with a magic wand, and gave them a fund to manage.

And it worked for a while.  After all, a monkey throwing darts at the Wall Street Journal stock pages could have made money in the midst of the greatest bull market ever.  Many of these new managers were under 30 years old.  They believed in the “new economy” and decided that things were different this time, since they had known nothing but an increasing stock market virtually all of their careers.

The article cites statistics that say since 1997, only 43% of mutual fund managers with less than five years on a fund beat the S&P 500, whereas 62% of managers with 10+ years beat the S&P 500.  This leaves the obvious impression that experience pays, and it does.

However, you have to be careful of such statistics.  The article says nothing about the type of funds managed.  There are obviously funds that were never intended to match or surpass the performance of “the market,” as expressed by the S&P 500 Index.  In those cases, even the younger managers may have attained the objective of the fund.

In addition, note that the statistic mentions managers with less than five years “on a fund.”  Since the article did not provide documentation of this statistic, we could assume that even a seasoned manager who was newly assigned to a fund because of a job change would fall into this category.  That probably explains why 43% beat the S&P, since I would suspect that figure to be much lower if the fund managers in question all had five or less years of total experience.

In a detailed due diligence situation, you must research the total experience of the manager, not just go by a “Manager Tenure” number on a software database.  Some managers change fund families and are new to their mutual funds, but bring with them a vast amount of experience.  Others are brought up through the ranks in management teams before they are given their own fund.  If a fund manager has been on a fund for just a short time, but has a long tenure with the fund family, it probably means there is a lot more experience there than what shows on the surface.  However, if his resume says that his greatest accomplishment of 5 years ago was being the captain of his college intramural soccer team, watch out!

Other Issues In The Article

I will not try to speak to all of the issues brought out in the Smart Money article, since doing so would take up far too much space and some of the "ten things" are interrelated.  Below, I will discuss the other major points of the article in terms of quality due diligence.  Not all of the criticisms are legitimate in every case, so I can use ProFutures extensive due diligence experience to shed additional light on each of these issues.

"I'll beat the market, someday."

Smart Money points out that there are plenty of mutual fund managers who have not consistently beaten the market.  The article says, "Not even a third of large-cap managers have out-performed the market over the past 10 years.  And yet some just keep hanging around."

How could this happen, you ask?  During the mid-1990s when the stock indexes were heading straight up, most mutual fund managers couldn't keep up.  However, there is a great deal of pressure in the mutual fund industry to try to match the performance of the major stock indexes, especially the S&P 500 Index, which has become the most common measure of stock performance.

In many cases, the fund managers simply "bought the index," meaning they invested in the same stocks that make up the S&P 500 Index.  Doing so would give them a performance that would closely follow that of the index, but it would necessarily be lower because of the fund’s operating expenses and loads, if any.  These managers were doomed to underperform the Index.

However, there is another side to this story that the Smart Money article did not address.  While the article’s analysis is accurate, and certainly describes many of the mutual fund managers out there, true due diligence requires that you ask questions beyond the obvious.  For example, one of the more simple questions to ask is, what market index was the fund expected to beat?  As I said above, the S&P 500 Index is widely quoted as a benchmark, BUT not all funds invest to compete with this Index.  Comparing a small or mid-cap fund to the S&P 500 Index is like comparing apples and oranges.  I have even seen bond funds compared to the S&P 500 Index.  What sense does that make?  None.

To be most useful, any analysis of a fund should be done in relation to an index that represents the market segment or sector which is the fund’s objective.  For example, if the fund is a small cap growth fund, then it should be measured against just such an index.

You also have to be careful of the source of the analysis.  Many financial journalists are so much in favor of index-fund investing, that they compare all funds to what the unmanaged (and inexpensive) index would have provided.  In fact, the Smart Money article contains a quote from a third-party “expert” saying poor mutual fund returns as compared to S&P 500 Index “make it tough to argue in favor of active management.  Index funds are a better option.”

Oh really?  As of the end of September 2002, the S&P 500 Index has a peak-to-valley drawdown of apprx. 46% (measured using end-of-month performance values).  The worst-ever single month’s performance is -21.54%, which occurred in October of 1987.  Index funds are NOT “better” investments for those whose risk tolerance is not such that they can stomach such large losses. This “one-size-fits-all” financial planning worked well in the mid-1990s when the stock market was going straight up, but it doesn't work well when the opposite is happening.  Wake up, financial media!

A thorough due diligence review should also ask the question, was the fund designed to beat the market, or to reduce risk?  Some mutual funds may never beat their benchmark because the goal of the fund is to provide returns similar to that of the benchmarks, but at less risk.  Minimizing risk usually involves moderating the return of the fund.  Clients who value risk management over “beating the market” gladly accept sub-index performance in return for lower historical losses.

Beating The Market, But Only In Selected Time Periods

On the other side of the coin are managers who do beat the market, but only in carefully selected time periods.  I once heard a remarkably candid money manager say that he could be the #1 money manager in the US, if you would just allow him to pick the time period.  What he meant was that many managers have periods in their performance record when they beat the market averages handily - but not very often.

Make no mistake, mutual funds, hedge funds, and managed account Advisors are all quite deft at selecting the time frame during which their program beats the market.  Some even use benchmarks other than the S&P 500 Index to prove their case.  This is fine if the alternative benchmark chosen is appropriate for the investment style of the fund, but this is not always the case.

While there are many mutual funds and money managers that significantly underperform the market in terms of both returns and risk, there are others that do not beat the market for good reason, or who show to beat the market, but only over a carefully selected time frame.  A detailed due diligence review is necessary to validate performance claims, select the most appropriate benchmarks for comparisons, and avoid manipulation of historical performance time frames.

Good luck finding out who's in charge.

This item in the article discusses that it is sometimes hard to identify just who is running the fund.  The inference is that some mutual fund companies have purposely made it difficult to find out when a key manager leaves the firm for fear that it would lead to mass redemptions. 

In some cases, this is true, but in others it is not.  Some funds successfully use a “team approach” to management, just so that investors won't be left out in a lurch if one of its team members leaves.

This is where on-going monitoring of fund selections is so important.  At ProFutures, we subscribe to a monthly fund update that tells us each time there is a management change in a fund we recommend.  That way, we can then review whether the fund is team managed or not.  If the fund is not team managed, and the key manager leaves, then this alone is grounds for taking the fund off of our recommended list for a time until the new manager is proven.

“I buy stocks for your account…and have no good reason why.”

The Smart Money article points out that some managers have a short-term outlook, and others trade just to show that they are doing something.  Either situation can lead to losses in the market and to negative tax consequences for investors in non-tax-deferred accounts.

As for any mutual fund that buys stocks just to show some activity, that practice is inexcusable.  All mutual funds are required to have a board of directors that is charged with the responsibility of looking out for the interests of investors.  If a manager buys and sells stocks just for show, it means the board of directors is derelict in its duty.  In fact, the article points out that many boards are nothing more than a committee that rubber stamps the actions of the fund manager.

In such cases, how is an investor supposed to know whether a purchase is beneficial for the fund or not?  At ProFutures, we continually monitor funds and managers that we recommend for something called “style drift.”   A fund will encounter style drift if, for example, it is a large-cap growth fund and it begins to purchase small-cap stocks.  For mutual funds, we use a software system sponsored by Morningstar that automatically warns us if  a fund experiences style drift.  For independent money managers, we monitor daily trading activity in order to spot any style drift away from the stated trading strategy employed by the manager.

“I've got a lot more on my mind than your account.”

This affects both mutual fund managers as well as professionals offering managed accounts.  Mutual fund managers are usually paid based on the amount of assets they manage.  Therefore, it is a temptation for a manager to take on more than one fund, or too many accounts, in an effort to maximize compensation.  However, doing so can overload the manager to such an extent that performance in all funds suffer.

As I said above, some mutual fund companies manage via a team approach.  In such cases, a manager’s name may appear on multiple funds as a member of the management team, but this does not mean the same manager is single-handedly calling the shots for all of the funds.  A manager serving on multiple management teams is not viewed as a big problem, whereas a manager making all the decisions for a number of funds can lead to disaster, in terms of returns.

In addition to multiple mutual funds, some managers also oversee trading in variable annuity sub-accounts and even separate accounts for high net worth clients in an investment advisory firm affiliated with the fund sponsor.  The tendency to overextend the manager is likely to become more intense now that many mutual funds are experiencing huge outflows of money, and fund families are laying off managers. 

As for professionally managed accounts, many offer the look and feel of customized accounts with a lot of personalized attention from the manager.  In many cases this is accurate, but some professional managers utilize computerized programs that allow them to take on many more clients than the manager could conceivably manage without help, much less customize a portfolio for each client.

In some cases, this is just fine, especially if the client is not looking for individualized attention.  However, clients who are looking for tax-sensitive investment strategies or who desire socially responsible investments may not be best served by a high-volume money manager.

The answer to finding overworked fund managers is again found in detailed due diligence.  Knowing how many different portfolios a manager is responsible for is a key ingredient of any due diligence review of a fund or professional manager.  Since detailed performance information is available through various software applications, it is relatively easy to see if a fund's performance has been negatively affected since a manager took on additional funds.  Unfortunately, most investors don’t have such software.

As for personal attention, it is often not advisable to look for the best money management and the best client care and communications in the same place.   Many money managers are good at just that - managing money.  They do not excel in client relations nor do they desire to.  That is why organizations such as ProFutures are necessary.  We not only provide due diligence and monitoring services for our clients, but we also provide client communication and business development services for the money manager.

More Helpful Due Diligence Hints From ProFutures

The Smart Money article is certainly helpful, especially for investors who do not work with a firm like ProFutures.  But as you have read so far, I have been able to show that there are many additional nuances, even within these general categories, that require more extensive due diligence review. 

Since performing due diligence on money managers has been a large part of Profutures’ service to our clients, I can add a few more areas that must be addressed before placing money in any investment.  Please note that the comments below relate mostly to independent professional money managers, but the principles can be used for virtually any type of investment offering:

1.  Is the performance record for real?

Since Advisors are not subject to the rigid performance reporting criteria applicable to mutual funds, an audit of the performance numbers given by the Advisor is imperative.  In some cases, the Advisor has already taken the step to have its performance audited by an independent accounting firm.  In cases where an independent audit is not available, ProFutures requires the Advisor to provide detailed records of actual accounts, randomly selected, usually in the form of monthly brokerage or mutual fund statements.  We compare the actual results in the accounts to see if they match the performance record provided by the Advisor.  Believe me, they don’t always match!  On more than one occasion, we have visited Advisors that advertised outstanding results, but when we looked at the actual account statements, we found that the real performance was very disappointing.  If so, we pack up and leave, right then and there.

It is important to note that individual investors may find it difficult or impossible to get this kind of information from an Advisor.  While Advisors regularly provide such detailed information to another RIA like ProFutures, they are hesitant to make detailed client information available to a prospective client, unless it is a very large investment.  Because ProFutures represents many clients and a large potential investment base, Advisors usually have no problem in providing information necessary to confirm their performance numbers.

One last point on the performance record issue.  Often in the past, I have had Advisors tell me that they could not show me account statements from their clients for confidentiality reasons.  Let me tell you, that’s a crock!   The routine practice is to “white-out” the name on the statements.  If an Advisor tells you he can’t do this, consider that a big red flag.

2.  Is there a strong back-office to handle administrative issues?

Successful Advisors must have a good performance record - that's a given.  But that’s just where it starts.  Once an Advisor generates a signal to buy or sell, the administrative staff must be sufficient to implement the trades, see that they are executed properly and make sure they are allocated in the correct amounts to all the Advisor's various clients.  This operation is commonly referred to as the “back-office.”   In addition to the back office, there must be adequate administrative staff to be able to interface with clients and firms, like ProFutures, who recommend the Advisor’s investment programs.

The best way to determine the sufficiency of the back-office operation is to conduct an on-site visit to the Advisors offices.  In such a visit, all facets of the administrative side of the business are reviewed.  This includes everything from how the system works, to trade execution to client statement generation and all other elements of the business.

In particular, it is important to determine that the Advisor’s staff is equipped to handle not only the current assets under management, but even more.   Remember, if an Advisor continues to be successful, it will definitely accumulate a larger number of accounts and more assets under management.  Ideally, the Advisor will have a long-term growth plan for adding administrative personnel at successive levels of increased assets under management.  While not imperative, we also like to see that the Advisor has a serious commitment to the latest computer hardware, software, technology and the personnel to run it.

This is not to say that an Advisor must have a large number of employees to be considered successful.  Many Advisors have outsourced administrative tasks to independent custodians such as trust companies, brokerage houses, and even mutual fund families.  The on-site due diligence review helps to confirm that these resources, coupled with the Advisor's internal staff, can handle any level of increased business that ProFutures or others may bring about.

The on-site visit has another beneficial outcome.  It allows the ProFutures staff to meet and talk with all of the principals and staff, and get a good feel for the organization as a whole.  

3.  Regulatory skeletons in the closet?

The Smart Money article discusses registration issues as a protection against fraud, but only as they apply to specific securities.  The article infers that registered securities are safer than unregistered securities, but holders of registered Enron stock may dispute that claim!  As a practical matter, most professional money managers do not offer registered securities, but rather manage money under the Securities Act of 1940 as a Registered Investment Advisor (RIA).  Thus, the regulatory history of the Advisor is of utmost importance.

Appropriate due diligence requires that the regulatory history of the Advisor’s key personnel be checked out.  This is accomplished through review of required disclosure information, a search of the SEC regulatory database, thorough background checks, and a review of any reports from on-site SEC examinations.

It is also important to realize that many Advisors also have affiliated companies that may be registered under other regulatory bodies such as the National Association of Securities Dealers (NASD) and/or the National Futures Association (NFA).  The due diligence process should include a review of the regulatory histories of all such entities.

In addition to regulatory background checks, the principal traders are also questioned about any significant personal situations that have occurred in the recent past.  It has been shown that an Advisor’s performance can be affected by a significant personal event, such as the death of a loved one, marriage, divorce, or geographical move.  All of these factors are also taken into consideration while doing a background check of the Advisor.

4.  Does the manager have a backup plan in case of emergency?

Ideally, an Advisor will have a back-up plan in case of emergency.  This could mean anything from a medical emergency or death, to an extended vacation, or even a power outage.  We want to see that trading can continue and that client accounts will continue to be serviced.  Some Advisors are “one-man shops” with no such backup, so they are generally overlooked when considering potential Advisors for our clients.

Even if an Advisor has a sufficient administrative staff or has outsourced back-office operations, this is no guarantee that someone could trade effectively in the absence of one or more of the Advisor’s principals.  The optimum situation is that the Advisor has at least two or more individuals who are familiar with the trading methodology and can continue the investment programs in the absence of the primary trader.

As a bare minimum, an Advisor should have someone designated who could unwind existing trades and take the program to cash, especially in the situation where the Advisor has died or will be out of the office for an extended period of time.  This allows investors to know that their accounts will not be locked into a trade during unfavorable market conditions because of the Advisor's absence.

5.  Does the manager continually monitor the system and make adjustments?  

A due diligence review of an Advisor should also determine if the Advisor is using a “vintage” system that never changes, or constantly monitors and adjusts the system for current conditions.  In the last few years, we have seen market conditions that have no parallel in the past.  Therefore, many Advisors' trading systems were blindsided and generated huge losses.  Being able to adapt to ever-changing markets and market conditions is one of the most important due diligence requirements we have at ProFutures.

This is not to say that the Advisor should tinker with the trading system so much that the program may be significantly different from one year to the next.   The type of changes I am talking about involve adjustments and refinements to the program to stay current with the ever-changing markets, technologies and information flow.

At ProFutures, we require all recommended Advisors to notify us prior to implementing any material changes to the trading system.  In addition, we monitor test accounts established with each Advisor on a daily basis so we can pick up on any changes in the trading methodology that the Advisor may have neglected to tell us about.

6.  Do they invest their own money?

Of all of the additional due diligence requirements that I have, this is one of the most important.  It needs little explanation.  Simply put, if I am going to entrust my clients’ money, and my own money, to an Advisor, I want to know they have a substantial percentage of their own money in their programs.  If an Advisor doesn’t have his own money in his program, I consider that to be a major red flag.

Interestingly, most of the successful Advisors I have met have a huge amount of their own money invested in their programs - often more than they should.  I am certainly no exception to this rule as I have a substantial amount of my net worth invested in the programs recommended by ProFutures.  It is my money invested in every program we recommend that serves as our “test accounts” that we use to monitor the results.

Conclusions

Between the analysis of the Smart Money article and the additional due diligence considerations from ProFutures, you should have a pretty good idea of what it takes to evaluate mutual fund managers, managed account Advisors, and hedge fund managers.  Now all you have to do is apply these principles to the thousands of available funds and Advisors in the marketplace.

Unfortunately, most investors never take the time to ask even a fraction of the questions necessary to get the information discussed in this article.  Most also have no ambition to travel all over the country and conduct this type of intense due diligence.  Even if they did, most investors are not equipped to evaluate the answers given to many of the questions discussed above or the operations of funds and Advisors. 

This is not to say that most investors are not capable of asking the right questions and demanding honest answers.  It’s just a LOT of work, and a great deal of experience is necessary.  I have been continuously evaluating money managers and funds for over 20 years.  Today, more than ever, it is still a continuous learning experience.

As noted earlier, some Advisors will simply not make all of the information discussed above available to an individual investor, especially one who is interested in opening up only a relatively small account.  As a result, individual efforts to perform effective due diligence on funds and Advisors usually ends up in only partial success, if not complete failure.

The good news is that ProFutures already has the staff, expertise and experience necessary to engage in the due diligence process on behalf of our clients.  We also have the necessary hardware, software and database applications to be able to monitor performance on a daily basis as well as identify new prospective Advisors.

If you are interested in the programs recommended by ProFutures, give one of our Investor Representatives a call at 800-348-3601.  You may also contact us via e-mail at mail@profutures.com .   Before calling, feel free to visit our website at www.profutures.com to learn about the kinds of investment programs we offer.

Finally, as noted on page one, I have pulled my copyright protection on this issue of Professional Investing.  You are free to share it with friends or relatives that you believe would find it useful.  As you have read, there is a lot of good information in these pages that you are not likely to find elsewhere.