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Graham Bentley: The unlikely key factor in picking a discretionary fund manager

Establishing the approach to qualitative versus quantitative analysis should top the due diligence list

As more advisers outsource investment decisions to discretionary fund managers, the more the regulator will scrutinise the selection process. I would not be surprised if DFMs were selected on a lazy combination of brand, price and performance, yet any being offered the chance to pitch for the privilege of managing clients’ money should at very least complete a request-for-proposal document.

This should certainly investigate price, performance and the likely cultural fit of the adviser’s team and clients with those of the DFM, but at the top of the list of questions should be an examination of the manager’s investment philosophy and process.

Seeking the DFM’s view of the passive/active schism is probably pointless; responses will simply offer the two options plus a blend anyway. However, there is a more fundamental question at the heart of the due diligence process: an inquiry into managers’ approach to qualitative versus quantitative analysis. According to stereotype, “quants” are analytical personalities, happiest when poring over company or fund reports, and economic data.

Qualitative investors, meanwhile, rely on people. They are said to be more creative individuals who can assemble scenario analyses and consider themes, such that leftfield opportunities for growth can be identified. They need peers, colleagues and especially corporate representatives to help stimulate and confirm their thinking.  However, that leaves supporters open to all the psychological biases humans exhibit.

Ben Graham, the “father” of value investing and perhaps the first quant investor, considered his profession to be “security analysis”. He only used companies’ data – available to everyone – to make his decisions.

One of his most famous aphorisms was that the market was a voting machine in the short term (who do you like?) and a weighing machine (the fundamental worth of a company will dictate its price) in the long run. In essence, his approach was to buy at a reasonable price and the company would look after itself. He felt no need to meet the boss.

Qualitative investors, on the other hand, believe you should buy the right company or fund and the price will take care of itself.

It is often said Graham’s star pupil, Warren Buffett, eventually eschewed quant proponents, citing “qualitative investment is really what makes the cash register sing”. In fact, Buffett remained a firm advocate of quant analysis but opined that the really “sensational” ideas he had came from what he called “high-probability insight”. It was this that extracted tunes from the tills.

That said, he admitted these were rare events, both for him and investors at large, and since no insight is required from quant (“the figures should hit you over the head with a baseball bat”), the “sure” money tended to be made by more obvious quant opportunities, while the “big” money was made by the rare, successful qualitative approaches.

While Buffett’s business Berkshire Hathaway tends to buy whole businesses (for example, Duracell), it does manage an equity portfolio of around $26bn (£20bn). It employs only two portfolio managers, neither of whom has hired analysts. In other words, two people each manage $13bn without the support of a phalanx of researchers. They are also paid on index-beating performance.

I cannot imagine they look at every stock on the planet or make 1,000 company visits a year.

Quant does have its drawbacks. The wider cohort of fund managers and selectors would rather analyse wads of economic charts illustrating obscure data relationships, possibly because that is what is expected of them. The more complex the task, the more expertise (it is assumed) is required to implement it, which in turn demands more reward.

The cost of an entire investment team is vast; little wonder the idea of price reduction for active management struggles to find disciples in investment management circles.

At asset allocation level, some quant analysis depends on algorithms. These are a series of “if, then” computer calculations designed to identify changes in the vast array of global economic data and how these are expected to influence market behaviour.

Qualitative analysis, meanwhile, will have a more thematic, and hence glacial, approach that attempts to profit through longer-term forecasting of complex economic and asset class inter-relationships.

It relies on insight and, to a great extent, hunches. It can be exceptionally profitable when a contrarian view proves correct, but extraordinarily tough to do. Many a qualitative manager has been let down by the apparent “no-brainer”.

Buffett’s approach is to ignore macro opinions and the market predictions of others, which he considers a waste of time and even dangerous, because it may blur one’s vision of the facts that are really important. Forecasting precise changes in the economic climate is infinitely more difficult than making a rough estimate of a company’s future earnings. Thinking about what the security will produce in the longer term, rather than daily valuations, is the key. As Buffett himself has pointed out, “games are won by players who focus on the playing field, not by those whose eyes are fixed on the scoreboard”.

Qualitative analysis requires more work and resources, and the cost of that is inevitably passed to the investor. Quant, at stock level at least, relies on computer support and mathematical models, such that analysis requires monitoring, not investigation and “insight”. Nor does it require too many people. It can be delivered significantly cheaper.

Advisers will learn a lot about a DFM’s suitability by considering detailed responses to these questions and others.

Graham Bentley is managing director of gbi2

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