In July of this year, an intensive exchange of ideas between investors and product providers took place at FundForum International in Monaco as part of a panel discussion on the topics of family offices, due diligence, and fund boutiques. Marcel Müller from HQ Trust in Bad Homburg, one of the family office representatives, was one of the panelists and addressed issues such as track record, decision-making processes, active share, and the topic of career risk in the area of manager selection. Moderator Markus Hill* spoke on behalf of FONDSBOUTIQUEN.DE with the fund selector following the intensive expert discussion.
Hill: At the Fund Forum Panel in Monaco we had the opportunity to exchange views on the topic of manager selection in family offices. Every house has its due diligence criteria. What is your approach to the selection of fund managers?
Müller: At HQ Trust we have a very stringent and systematic selection process. In the first step, we carry out a quantitative screening, which first gives us a good overview of the risk behaviour and performance of the peer group. Key figures such as volatility, upside capture, downside capture ratios, and active share play a greater role here. However, for us, this is initially only a tool for generating ideas. The focus of the selection process at HQ Trust is strongly driven by quality. Why qualitative? We believe that asset management is a people’s business and that the quality of portfolio management has a significant impact on fund performance. And this requires a detailed qualitative due diligence of the fund managers and their teams. It is therefore extremely important to interview the people involved and to visit them on site. We also send out very detailed questionnaires, some of which can be up to 100 pages long. The evaluation of the questionnaires is especially important for the preparation of an on-site due diligence appointment. It is important to understand why a fund manager has achieved good results in the past and whether this can be systematically repeated in the future. This cannot be done purely quantitatively via a fund database. We, therefore, analyse the fund managers’ investment processes very closely and pay particular attention to competitive advantages in the analysis and processing of information. What sources of idea generation and how many potential alpha sources does a fund manager have? Do these ideas find their way into portfolio construction and ultimately into the portfolio? How high is the quality of the risk management system or is it applied at all? Can the fund manager explain his performance at any given time and does the investment process fit the investment philosophy? Conclusion: It is more important for us to understand a track record than to buy a good track record.
Hill: Interesting point. What exactly do you mean when you talk about buying a good track record? There are also managers in the market who show weak phases in their performance. How do you deal with this? Is decision-making processes in the team often more difficult in this case?
Müller: I think one of the biggest misconceptions in our industry is the belief in the possibility that “past performance” can be bought. Although everyone knows that this is not possible, a great many market participants seem to succumb to this misconception. In most cases, past performance-focused fund selection leads to disappointing investment results. However, the fact that this historically focused approach is predominantly practiced and can be seen simply from the fact that funds with a good history of returns grow relatively strongly in fund volume as a result. These funds then often become too large and are restricted in their investment universe. The result is then usually worse results than in the past. I think some investors are sitting on this mistake. It is of course much easier and more pleasant to buy a fund with a good track record or to recommend such a fund to analysts. You need much better arguments to recommend a fund if it has not performed as well in the past. It also involves a certain degree of career risk for analysts. If you recommend a fund that has performed well over the years and the manager is very well known, then it is insignificant if the fund performs badly. With an unknown manager and possibly not so good performance history, you have to justify yourself more firmly. But the question is what ultimately leads to better investment results for our clients. We firmly believe that past fund selection is inferior to qualitative fund selection.
Hill: Would you see a difference in manager selection between the due diligence process of fund boutiques and the selection process of established, corporate managers?
Müller: We follow a structured and disciplined selection process for all funds invested for our clients. However, there are certain differences in the level of detail of due diligence for fund boutiques compared to one of the large global asset managers. Let me give you an example. A few years ago we selected a fund boutique with 4 employees. Several days were required for the on-site due diligence at the manager’s premises. On the one hand, we wanted to have the entire IT infrastructure (e.g. trading systems, risk management systems) explained to us and to understand exactly which portfolio tools were being used. Besides, it was important for us to get to know the people involved in the transaction and to obtain the opinions of existing customers, business partners, and former colleagues on site. It is also important to analyse the ownership structure as well as the stability and intensification of the investment team in detail, as the personal risk is usually much higher in boutiques. All in all, it can be said that in a boutique we tend to turn over every stone twice rather than just once. We think that this thoroughness pays off for our clients in the long run.
Hill: Many selectors are intensively observing different investment styles, and some houses have developed preferences here. Do quantitative strategies seem more promising or attractive than discretionary strategies?
Müller: I think there is no clear yes/no answer here. There are excellent approaches to both quantitative and discretionary strategies. With quantitative or rule-based approaches there is often the problem of a “style bias”, which means that these approaches often no longer work or generate underperformance when trends in the capital markets turn. It is therefore very important to ensure certain style neutrality and especially to pay attention to the valuation of the companies in the portfolio. At HQ Trust we have achieved very good results with both quantitative and discretionary approaches. We are more interested in identifying a high-quality approach with competitive advantages in the investment process (idea generation, analysis, and portfolio construction) than in “shooting for” a particular investment style. Whether this then happens on a discretionary or rule-based basis is secondary.
Hill: Many fund selectors often have interesting, intensive discussions in the field of active versus passive management. What do you think about this topic?
Müller: Basically, we as a bank believe very strongly in active management. However, we think that both have their raison d’être. In some peer groups, it makes sense to think about passive strategies, especially if the ETF is systematically in the first quartile of a peer group. Here it is important to note that the ETF is in the first quartile and not the benchmark. This is because nobody can buy the benchmark, which is particularly the case in illiquid asset classes such as convertible or high-yield bonds. In these asset classes, you will not find an ETF in the first quartile of such a peer group, if there is a comparable ETF at all. However, passive strategies also have their risks, which are due in particular to the construction of the underlying benchmarks. Take the common bond benchmarks, for example, which have the largest weightings in countries or companies with the largest debts and often the poorer credit ratings (e.g. Japan). If you invest passively, you may be investing very risky and often with a low return. For this reason, we have reservations about passive strategies in this asset class. Here, the more active the better it is. However, the use of passive strategies in very liquid and efficient markets such as USA Large Cap and Japan Large-Cap seems to make a lot of sense. Here you will find ETFs in both peer groups systematically over long periods in the first quartile. If you also take the selection risk into account, active management seems less attractive here. This may change, however, as equity benchmarks also have their risks. If index heavyweights become increasingly expensive due to constantly rising passive money, passive strategies in these peer groups may be less advantageous in the future than in the past. A good example is Latin American equities, where it was much more advantageous to invest via an ETF during the commodity boom in 2002-2007, but from 2008 to 2015 active management was very promising. Here it is important to observe closely and act accordingly. This is, by the way, also the interesting thing about our job, the dynamism!
Hill: Currently, people often talk about key figures like Active Share. How do you see the topic?
Müller: Active Share is an interesting key figure, and we have been looking at it closely for some time now. However, there are a few things you should bear in mind with this key figure if you include it in your decision-making process. For one thing, the figure in itself says nothing about the quality of the investment process. Furthermore, the ratio is only applicable to equities and not to other asset classes. Furthermore, the level of active share in general does not say much about the actual activity of the portfolio. It depends very much on the respective benchmark. It is widely accepted in the industry that an Active Share of over 80 is considered very “good” or “active”. However, this is not necessarily the case. Let me illustrate this with an example. In an index with many stocks such as the MSCI World, for example, you can achieve a high active share of 80 or higher relatively quickly, if only because you do not invest the majority of the stocks in the benchmark at all. If, on the other hand, you take a manageable benchmark such as the MSCI Latin America, for example, where the five largest index weights account for almost 40% of the entire index, an active share of 60 is already very high. So you can see that this measure should be taken with caution and always be considered concerning the respective benchmark. We use this ratio accordingly and prefer funds with a high active share and a high-quality investment process.
Hill: Many thanks for the interview.