How We Seek to Identify Great Active Managers
A Conversation with Litman Gregory Senior Research Analyst Jack Chee
The following Q&A article was originally published on AdvisorIntelligence (operated by an affiliate of Litman Gregory Masters Funds). The article discusses Litman Gregory’s due diligence philosophy and process with respect to mutual fund managers, which is the same process we use in researching stock pickers for Litman Gregory Masters Funds. In addition, with respect to the Litman Gregory Masters equity funds, we focus on investigating each stock picker’s ability to add incremental value by running a highly concentrated portfolio. Finally, the stock picker’s enthusiasm for being part of Litman Gregory Masters Funds is also assessed. The same group of Litman Gregory analysts are responsible for all of the firm’s manager due diligence.
Few questions have inspired as much debate among investors as the question of whether great active managers exist and can be identified. We believe the answer is yes, but not without caveats. Great managers are rare and, for investors, building a process to identify and select them requires an enormous commitment of time, effort, and patience.
Over the years we’ve written a lot about our manager due diligence process. Here we sit down with Litman Gregory senior analyst Jack Chee, who has been researching managers for nearly 17 years, 14 at Litman Gregory, and who is co-portfolio manager for the Litman Gregory Masters Equity Fund and the Litman Gregory Masters Smaller Companies Fund. In addition to being responsible for much of our fixed-income asset-class research, Chee has primary research responsibility for a number of the managers we follow including the teams at Sands Capital, Brown Brothers Harriman, Osterweis Capital, and Nuance Investments.
Below we discuss several phases of manager research and ask Chee how he uses precise questioning, data, and analysis in his due diligence for every manager he evaluates. We also include below a flowchart showing a streamlined version of our full process. While each of our analysts contributes individual judgment and expertise to the job, the overall philosophy and approach Chee highlights apply across the entire team. It is our hope that this discussion will bring our research philosophy and discipline to life for advisors, clients, and shareholders, as well as enhance the efforts of those who may also be in pursuit of great managers.
First Things First
Let’s start at the beginning of your manager due diligence process. Many investors screen on performance to identify new funds, despite the general understanding that past performance is not predictive of future returns. How do you begin your search?
We have to start somewhere and so, like everyone else, we often begin by screening for funds with compelling long-term track records. As a general rule, the longer the track record, the better. But in some cases, such as the capacity-constrained small-cap space, if a manager is successful, they can attract assets relatively quickly, and the strategy closes to new investors before a long-term track record can be established. So we are willing to look at funds with shorter track records. In fact, I intentionally run screens for funds with very short track records [i.e., less than a year]. In some cases, these managers have longer-term separate-account track records, or a manager may have recently left a firm to start their own firm. Examples of this are BBH Core Select and Nuance Concentrated Value. But in the case of funds with shorter track records, we raise our qualitative due diligence bar even higher because we have less history and information to understand how the track record was built [i.e., was it luck or was it skill?].
Aside from screens, some of us on our team have been in this industry for over 15 years, so we have a network of contacts and relationships with both the managers themselves and on the sales and marketing side of the business, which helps us find new ideas. We also read industry publications and websites to stay on top of opportunities. So we have a lot of different ways of trying to dig up new ideas. But I do not think we have a secret sauce, per se, in finding managers we want to do more work on. It is more a function of turning over rocks.
Are there certain performance or portfolio metrics that you emphasize?
Absolutely. At this stage in our process, if performance catches our eye, the next step is to see if there are any clues to what drove the strong track record. So when looking at performance, we might get the sense that the manager wins by losing less in down markets, or, conversely, outperforming meaningfully in strong markets. Then there are the other standard performance metrics that I suspect most analysts also evaluate, such as the volatility of returns, consistency of rolling returns, whether there is one strong or poor outlier year that materially impacts the longer-term track record, upside-downside capture, etc. In terms of portfolio metrics, we look at the number of holdings, the concentration or percentage of assets in the largest portfolio holdings, industry concentrations over time, cash levels, etc. There are also shareholder-oriented metrics, such as fund expenses, whether the fund family has a history of closing other funds at responsible levels, whether the fund family pushes managers to run additional products, etc.
Looking for a new fund – or sub-advisor, in the case of the Litman Gregory Masters Funds – is kind of like walking into a tire store. You see all these little round black things and you have to pick one. You have to break it down into: I drive in this kind of weather, I need this kind of tread life, I have this requirement for traction, I need it to run flat for x number of miles. You develop a profile of what you need. With funds as well, you’ve got to start breaking it down like this.
As you move beyond the data and try to gain clues into how a manager runs money, what do you find to be the most useful sources of insights into a manager?
What we find most useful are historical monthly or quarterly fund commentaries from the manager, going as far back as possible. Commentaries can offer useful insights into a manager’s philosophy, how they run a portfolio, and what they were thinking and how they structured the portfolio over different market cycles. We also try to dig up interviews the managers have done in the press to gain insights into their process.
We’re trying to understand as much about their process as we can, prior to speaking with the manager. We can take this pretty far. For example, when we started looking at Nuance Concentrated Value and Towle Deep Value, their commentaries included monthly buys and sells. Using this information, we built spreadsheets that tracked monthly buys and sells for years. This exercise provided a number of insights into the managers’ processes. It allows us to observe the typical holding period of their picks, a batting average—the percentage of winners and losers in the portfolio over time—and the magnitude of the contribution to performance, either up or down.
Using Nuance as an example, before we spoke to them we were able to observe that they look for singles and doubles, rather than swinging for the fences. We were also able to observe that they had a number of instances where they bought and sold the same stock over time, sometimes three or four times over the years. Each time they held these stocks, we saw the prices at which they bought and sold, and saw that there was about a 20% or 25% gain each time. So we started to get a sense of their investment universe and the types of companies they look for, and we got a sense that there was a strong valuation discipline.
Where the Rubber Meets the Road: Talking to Managers
Your process depends heavily on your personal interactions with managers and their teams. Is it pretty typical that you’ll do this much background research before even speaking with a manager?
We try. Not every manager is going to have monthly buys and sells in their commentaries. But to the extent that we can get this information, we will do this work.
Being armed with information is key when conducting manager due diligence. Running through a generic checklist of questions will not lead to success. For example, to simply ask a manager about a mistake doesn’t work because not only has the manager been asked that question a hundred times, they will take it a step further and spin their response in a way that makes it look as though they did a ton of research and ultimately it wasn’t their fault, and they did shareholders a favor, in fact, because they sold a stock when it was down 40%, before it slid another 30%. Their job is to assuage any concerns shareholders may have about their investment process. For this reason, I think it’s critical to steer the conversation. We have to approach due diligence through the lens of what doesn’t the manager want us to find out. This requires that we be intentional about what we are trying to get at, and how we are asking the questions. Ideally, we define one or two things we want to get at in a conversation. I think that’s a mistake that a lot of people make—not being intentional about what they’re trying to understand and why.
More broadly, what are some of the things you’re trying to uncover in your conversations with managers?
We need to understand all of the elements of their investment discipline. Every fund manager will tell you that they have “a disciplined and repeatable” approach. Every manager. We can’t just accept that. Our job is to understand how managers think and how they make decisions, and ultimately be able to define the guardrails of their investment process, or draw the blueprint of the investment process if you will.
The reason is, inevitably, every manager will underperform for some period of time, sometimes meaningfully. Unless you deeply understand the disciplines of the investment process, when the underperformance happens you will be left with a lot of guesswork trying to assess why the underperformance occurred, and whether to sell.
Let’s say you invest with a manager who outperforms for the first two years, and then underperforms in the third and fourth years. If you don’t thoroughly understand the process, in the first year of underperformance you may be willing to assign some goodwill to the prior two years of outperformance. But what happens in the second year of underperformance? It’s decision time. When do you throw in the towel? When is it too painful? When too many clients give you too much grief? That’s not a good way to make investment decisions.
In my opinion, it’s necessary to clearly understand the investment process and what makes that manager great, or else you don’t have a hook upon which to hang your investment-thesis hat.
You have to understand the linchpins of the investment process, so that when the underperformance occurs, you can surgically dig into mistakes, and assess whether the process is breaking down. It is the thorough understanding of an investment discipline that I think differentiates us.
Litman Gregory has often referred to the idea of a manager’s investment “edge.” Is that basically what you’re describing?
“Edge” is a buzzword that everybody throws around in the industry. An edge really boils down to the factors that enable a manager to beat the broader market. There are countless investment approaches, so an edge can come in different shapes and sizes and colors. Edge isn’t necessarily this unique thing that nobody else does, though it can be. Sometimes an edge could result from a team or firm doing the same things as everyone else, but just doing them better. Not different, but maybe everything they do is deeper and more thorough.
Take BBH Core Select, for example. I don’t think they’re doing anything different than anybody else, it’s just that they have a commitment to excellence in everything they do, from the thoughtfulness and quality of the team’s research, to how the team plans for growth, to how they ensure the investment process remains disciplined, etc. It’s a combination of several factors that results in their edge
What are some of the best ways you’ve found to get at information when speaking with managers?
I think a good approach is to ask a manager what they don’t do, and why. To give you an example, if you ask a manager why they just hired a specific analyst, you will get the obvious answers about their intellect and cultural fit. There’s generally not much value in that answer. But if you ask them about the 10 people they didn’t hire, not only are there more data points, but I find you can learn a lot more about what’s important to the process and team culture.
It gets back to being intentional about what you want to know and not just asking questions and then trying to sort through the information you get. A lot of times you’ll see people at an initial meeting asking questions like, didn’t that company just take on debt? The manager’s going to say, “Well, yes, they did, but . . . ”
You don’t even know if debt’s important to this manager yet. It sounds like it’s an easy thing. But there are so many qualitative dots that you have to connect that it’s not easy. It takes time, it takes patience, and it takes experience.
Is it important to meet with members of the team other than the lead manager?
Initially we spend most of our time with portfolio managers because we want to understand exactly what they do, how they do it, and why they do it a certain way—their roadmap or blueprint. Then we begin conversations with the analysts. We want to gain confidence that the team is following that roadmap.
Are the analysts researching companies in a way that’s consistent with the process that the managers have explained? If not, that can lead to a breakdown in our confidence. We also talk to firm management to understand the direction they want to take the firm. We might also talk to the traders, former clients, former co-workers, former co-portfolio managers, and former analysts as a way to verify our findings. We don’t take a cookie cutter approach to manager due diligence. Our approach will be specific to that manager, and what we feel is important to their process.
You talked about firm management and the direction of the firm. What are some of the operational dynamics that could raise red flags for you?
Every firm has to make a decision at some point as to whether they want to be performance oriented or asset oriented. A number of the managers who we have found more recently are managers who have been in the investment business for a long time, but started their own firm. In the past, they ended up running way too much money at the direction of the firm’s leadership, so they spun off. Then they’re committed to running a very small asset base, because they’ve previously done it the wrong way. They’re also hungry, because they want to prove themselves. That hunger is another intangible that we look for.
What might come up that would cause you to stop your due diligence? Or to not recommend a manager?
The goal of our initial conversations is to, as quickly as possible, figure out if an edge does exist. More often than not, we usually know pretty quickly whether we can identify an edge. If we get the sense that there’s an edge, the due diligence process continues. If not, research stops in the early innings. There’s a firm that we’re looking at right now and we spent two hours with them, and we came away with a really clear understanding of what they actually do differently—better than, we think, anybody else. We came away from that meeting saying, ah, this is their edge. So, yes, let’s meet with them again.
Also, at this early stage of research, you have to listen to your intuition. There are a lot of qualitative “squishy” factors that you pick up on during an interview that can help you decide whether to continue research. Does this manager live and breathe investing? What are their motivations? How do they define success? What’s truly important to them as a person, as an investor, and as a fiduciary?
Research Team Vetting
At what stage do you bring in the rest of the Litman Gregory analyst team?
It’s not formulaic, but generally speaking we have a preliminary team vetting when we feel reasonably confident that an edge exists and that we have done some verifying or stress testing of the components we think comprise that edge. In some cases we may have already conducted a site visit, but not always.
Our internal team vetting sessions can last for hours. The primary and secondary analysts researching the fund will lay out everything they know about the manager’s process: what they like, their concerns, areas for follow-up, an explanation of performance, and obviously the edge.
The other analysts will then play devil’s advocate by asking questions and trying to shoot holes in the research. After this preliminary team vetting, we continue our conversations with the manager and analysts. That can involve another site visit or several more phone calls. Then once we feel we’ve covered everything, we’ll do a formal team review.
How does the devil’s advocate role work? Is it one person or is it the entire team that makes sure the analysts doing the work are being completely open and unbiased?
The vetting process is always a team-oriented approach. When we conduct research on funds, we record the conversations we have with managers and get them transcribed so any of the analysts playing devil’s advocate can listen to the conversation or read a transcript to become deeply informed throughout the vetting process. They can then challenge us by saying, I don’t think you covered this topic, or, I read all the transcripts and I disagree with your opinion. It allows for better discussions. If the investment thesis can’t stand on its own legs, it’ll come out in the vetting process.
How do you monitor the managers on an ongoing basis?
If you think about it, we get a scorecard every day in terms of managers’ performance relative to the benchmark. Of course, we’re long-term investors; a day, a month, or even a quarter doesn’t indicate success or failure. What’s important to us is that the investment discipline remains intact. So monitoring the manager is critical. That’s where you have to assess if the process is breaking down. That’s as important as the initial due diligence. We verify this through conference calls, monthly and quarterly commentaries, semiannual and annual reports, and performance. We also have 60 to 90 minute calls at least twice a year with managers as a way to test that our thesis remains in place. Often we visit their offices or have them visit ours.
It’s also being able to understand what stocks are driving performance. Usually we’ll have a rough sense of when they bought a stock, so we can tell their gains and losses. We’re also paying attention to what they bought and whether we think that stock might fit the process for a certain manager. In terms of what they sold, we might observe a significant loss. We’d note that down and make sure we talk about it the next time we speak to them. But if something happens at the firm or team level that we consider material, we call them immediately.
One of the questions that we often get is how we avoid getting complacent, particularly with managers we’ve worked with for a very long time—20 years in some cases. So when do you sell a manager and how does performance figure into the equation?
In terms of falling in love with managers, my personal philosophy is that it’s business. If we lose confidence, we’re not going to be the first ones to fire a manager, nor will we be the last. It comes down to conviction, and our conviction rests on the shoulders of our qualitative assessment, rather than performance.
One of the managers we recently sold was outperforming their benchmark on a trailing 12-month basis by nearly 20 percentage points at the time we sold. People can say performance drives decisions, but this is a clear example where that’s absolutely not the case. Based on performance, we had every reason to stick with that manager. But we sold them because we thought there was an issue at the firm level that made us very uncomfortable. Subsequently, our concern played out.
That’s why it’s important to really understand the disciplines and the process. That’s all you can keep coming back to. Otherwise, decisions are made based on emotion and you can get whipsawed.
Is this part of your follow-up with managers?
Yes. You always “trust but verify.” That’s a big piece of it.
Anything we see that doesn’t seem consistent with the discipline will be a topic of discussion. One slight inconsistency might be okay, provided they give us a decent rationale for it. We’re not just going to sell because there’s one odd stock in there.
But if you start to see the same patterns repeat over time, that’s when we push really hard. The leash gets shorter. We challenge more. The same with performance—the longer the period of underperformance, the shorter the leash gets.
What are some of the clues that there may be cause for concern?
One problem is that most managers are extremely smart and articulate, and their job is to assuage any concerns. And they work hard at it. So you constantly have to be on the lookout for what can go wrong. I think you just have to be a pure skeptic. Also you have to have things to look out for—the key risks.
Unless you have those and unless you write them down on paper, incremental changes could happen that you let slide because each one, in and of itself, doesn’t amount to much. But all of a sudden you have 10 little things and it’s no longer the manager that you initially bought.
I think you have to identify or be aware that things can go wrong. If you’re not looking at it from that perspective, you’re just going to own the fund forever.
Bringing It All Together
Obviously we have a lot of access to managers. For investors out there doing their own fund research, how can they really get at some of the same information?
The truth is, they can’t. I don’t think an individual investor has anything more to go on than periodic manager calls, annual and semiannual reports, and quarterly commentaries. They’re not going to get the access.
We can spend 40 hours talking to a manager, and that’s not even counting the analyst team, co-managers, and other people at the firm.
So when Jack Bogle of Vanguard says finding an active manager that can outperform is like finding a needle in a haystack for most investors, I would agree. That’s why the value of an index fund is huge for individual investors. They don’t have the access. They can’t spend the time to differentiate between managers who are average and those who are great.
That’s not their sole job, either.
Right. Not only are we talking to managers and the teams for hours, but we’re in our office around this table for hours marking up whiteboards, etc., to really help us understand what it is that we truly like about this manager. What are the risks? What could go wrong? Going through the scenarios. What if each of those five people left? What if person A leaves? What does that mean to our opinion? What if person B leaves? What does that do? If you haven’t talked with the team for hours, you can’t do this.
Also working in our favor is that we have a really broad reach through the assets we manage and also through AdvisorIntelligence. So firms want to talk to us and are willing to give us a lot of time. I think the amount of upfront work that we do helps us gain access to managers. We often get e-mails or comments from managers who say, “That was a really interesting conversation; I would love to have more of these, because I never even touched the pitch book.” Or, “Man! That was a lot! I’ve never been asked those questions before.”
I don’t mention that to be egotistical. It’s just that we love doing this piece of it. We love manager due diligence, and it’s a big part of what we do.
I think when you have mutual respect for each other, you build rapport. With better rapport you also get more frank responses.
You also have the benefit that you’re not just a market timer that’s in and out of funds. You’re good long-time shareholders.
Any final thoughts on how to get better insights on a manager’s edge?
Somebody said something intriguing to me recently. He said, most things, as you get closer to them, get bigger. If you walk up to a building, it gets taller. Or a rock or a lake. Anything that’s an object—as you get closer to it, it gets bigger. He said the one thing that often gets smaller as you get closer to it, is success. I find this to be particularly true in this business of asset management. In other words, as you talk to managers and owners of fund families when they run smaller asset bases, they often lay out their goals for asset growth. But a few years later, they reach those initial goals, and you realize that their definition of success has moved farther away.
This has actually led me to deeper conversations with managers about how they define success. This is the intangible stuff that you can use to help really understand who a manager is and how they’re ultimately going to run your money.
I have come across managers who I think are in this business to make a ton of money. For others, I can say money’s not all that important to them. That doesn’t mean that one’s right and one’s wrong, or one manager is better than the other. These are all qualitative inputs into consistency of style and process. There are numerous intangibles that matter in manager due diligence. But ultimately to be a great manager they have to be disciplined and create value with a sound investment process.