6 Tough Questions to Ask Your Portfolio Manager

A t a recent meeting with a long-time client, I found myself bemoaning the fact that it is extraordinarily difficult for consumers to ‘buy’ investment advice. Today’s financial markets are confusing, as are the many different strategies for managing money, and consumers are often left not knowing what to ask (or even, where to begin). For starters, if you don’t know, ask how your manager gets paid, how long he or she has been in the business, and how often the manager communicates with clients. After throwing those softballs and watching the manager hit them out of the park, here are six additional questions that are a little more subtle, and are sure to give you important insights into how a portfolio manager approaches portfolio construction and manages risk.

I suggest you hurl these thunderbolts in a soft voice and with a pleasant demeanor. Then sit back and let the fun begin.

1. Do you think markets are efficient?

This is a loaded question. Investment advisors who believe markets are efficient, or nearly efficient, are more likely to counsel you to buy and hold a diversified portfolio of asset classes with the assumption that investment assets are always fairly valued. The corollary to this point of view is that even if markets are not fairly valued, investment advisors cannot consistently recognize value opportunities. Investment advisors who feel that markets are inefficient believe that investment markets are often undervalued or overvalued, and present opportunistic investors with the chance to deliver excess returns over and above the market’s returns.

The status quo in the investment community for the past four decades has been to buy and hold a strategic or static asset allocation and patiently wait for historical average returns to be earned. If a portfolio manager tells you that “no one can time the markets,” then you might ask them how they plan on earning the returns that you will need to accomplish your objectives if financial markets continue to deliver less than expected returns for an extended period of time. If the answer is “to be patient,” seriously consider whether you can afford that particular strategy.

2. If you actively manage the portfolio by changing the asset allocation, how do you determine what asset classes are good and bad value propositions?

Make sure everyone is on the same page when asking this question. You are not asking how a portfolio manager decides which stocks or funds to own within the stock or equity allocation of your portfolio. You are asking how a manager decides to change the overall allocation to stocks in the portfolio.

There are three basic methods for determining value and most portfolio managers will promote at least one (and possibly more than one) as being the best method for earning excess returns:

1. Traditional methods of valuation like price-to-earnings ratios, price-to-book ratios, and price-to-sales ratios (think Warren Buffet here)
2. Valuating the market cycle by evaluating a variety of economic indicators like spending, wages, interest rates, real estate sales, manufacturing data, etc.
3. Evaluating investor behavior by studying market trends, investor sentiment, market divergences, market breadth, mean reversion, etc.

Consumers should try to understand the process a portfolio manager uses to make decisions about adding and subtracting risk from the portfolio. Portfolio managers can be very persuasive that their techniques for identifying value are better than others. Beware: Any one of these three methods of actively managing portfolios can stop working for an extended period of time.

3. How do you make investment decisions?

Most investment professionals subscribe to one of two philosophies about making investment decisions. One camp believes in “rules based,” or quantitative decision making. The purpose of using mathematical models to determine portfolio allocation is to avoid the many pitfalls of human decision making. The Nobel Prize winning field of behavioral finance explains how we are biologically doomed to make errors in judgment when making investment decisions. Investors are subject to a variety of biases and heuristics that make it difficult for us to make objective decisions.

The second camp of investors believes in using judgment, experience, and intuition to make investment decisions. They point out that misusing investment models has been responsible for dangerous amounts of market misbehavior over the past decade. They further claim that bad assumptions and blind belief in model results have resulted in financial derivatives that massively add to systemic market risks. Consumers should consider how an investment provider makes their decisions and should be comfortable that the process is reasonable and repeatable.

My advice is that both qualitative and quantitative methods are fraught with risks. An advisor who is too dogmatic about either deserves your skepticism.

4. How have you performed throughout a complete market cycle?

A mistake made by consumers of investment management is that they often analyze investment performance based on one time frame. Try to evaluate a manager based on how they performed over many different market cycles. A manager that performs well in both bull and bear markets should be highly valued. Make certain that one good call isn’t responsible for an outsized portion of a manager’s return. This March was the three year anniversary of the beginning of the bull market that took the S&P 500 Index from an intraday low of 666 to last Friday’s close at 1278. Is the manager still showing trailing three year numbers? You might be surprised at the number of managers who missed the bottom but went to cash during the preceding bear market from October 2007 and ending in March 2009. If the manager missed the bottom, and a lot of them did, then make certain you understand the ‘why’ of their decision making process (You may actually agree with the manager’s reasons for underperforming in a specific market environment).

If a manager’s three year numbers have mysteriously disappeared from their performance presentation, you might consider running for the exit.

5. When was the last time your investment process failed?

This is one of my favorite questions. You can often find out more about a portfolio manager from his or her failures than you can from the successes. Obviously it is important to find out if there is a flaw in the portfolio manager’s decision making process that reduces your confidence that they won’t make a similar mistake in the future. In my opinion there is no investment process that is flawless, because active management involves changing the risk characteristics of a portfolio based on an assessment of the probability of future events. Since improbable events happen all the time, investing is often about being right more than you are wrong, or at least minimizing your mistakes. So make certain you fully understand the mistakes a manager has made in the past. They are a valuable tool to understanding the manager’s investment process.

Equally important is the way that the manager answers this question. If he or she is defensive, then run, don’t walk, out of the interview. If the manager implies they rarely make mistakes, or has only made one or two mistakes, then once again your flight reflex should take over. On the other hand, a manager who talks openly and honestly about their investment mistakes, and inspires confidence that they are learning as they go and are not likely to make the same mistake for the same reason, is a manager who should be highly valued.

6. Are your returns back-tested?

There is a potentially terribly misleading method of presenting investment returns that is called “Supplemental Returns.” An investment manager is allowed to present the returns he or she might have earned in the past if they had managed a portfolio as they do in the present. By back-testing a rules-based portfolio a manager can show an amazing historical track-record of returns, even though they were never actually earned. As long as it is disclosed that the returns are supplemental, and as long as the manager’s actual earned returns are disclosed elsewhere in the returns presentation, then he or she is technically following the rules for presenting performance.

If a manager is presenting back-tested and hypothetical returns, then you should ask why the supplemental presentation is believable. In addition, if a manager doesn’t make it perfectly clear that the returns are hypothetical, then (once again) you should bolt for the door. There are perfectly good reasons why a manager might present supplemental returns – just be sure that he or she explains them to you in a credible way.