Star manager start-ups – due diligence considerations

By Dan Hallett, CFA, CFP on April 29th, 2012

Some retail mutual fund companies are traditional money management firms that have a single guiding investment philosophy driving the management of all client portfolios – and the in-house firm is the only manager of the funds on offer.  Others have no in-house money management firm.  Instead, they seek out external portfolio managers to make day-to-day investment decisions for the firm’s funds.  The trend of late has seen the latter hiring ‘star’ portfolio managers’ via their new start-up firms.  It’s easy to see why this is happening but it raises a few questions from a due diligence standpoint.

The trend

Brad Radin started  his own firm last year shortly after leaving his long-time employer Franklin-Templeton.  IA Clarington quickly snapped him up to run a couple of its global funds.  More recently, they struck a deal with fund manager David Taylor’s new firm, Taylor Asset Management to run a couple of forthcoming new funds.

Another such announcement saw Northwest Ethical Investments sign an exclusive retail agreement with Otterwood Capital Management – the new firm of former AGF star Christine Hughes.

While all of these managers have terrific track records, these newer partnerships raise issues from a due diligence standpoint.

New entrepreneurs

The first issue pertains to the heightened business risk of start-ups launched by new entrepreneurs.  Every new entrepreneur – no matter how well prepared – likely underestimates how tough it is to launch a new firm and how much work is involved.  One such manager recently stated an intent to spend 100% of the time running money and that as many people as necessary would be hired to make that happen.

This very good good manager is either being unrealistic or is giving a bit of a sales pitch because it’s not that simple.  So the risks here are twofold.  In addition to the aforementioned business risk there is the chance that the main money management talent will be distracted or pulled away from running money and more toward running the business.

Performance ‘ownership’

The next big issue is more complex.  It pertains to the age-old question of whom do those past performance numbers belong to – not from a legal standpoint but from an ‘influence’ point of view.  Some research suggests that, generally, 70% of past performance is attributable to the firm (and associated investment team and infrastructure) while only 30% is attributed to the individual lead manager.  In cases like David Taylor, however, the percentages would probably flip the other way i.e. more heavily in Taylor’s favour.

For most of Taylor’s nine years at Dynamic, he worked largely on his own.  Initially, he worked more closely with a couple of his value team colleagues.  Over time, however, he developed analyst and CEO contacts outside of the firm, relying less and less on Dynamic’s in-house investment team.  But he still benefited from the fact that other people took care of compliance (a biggie), went out and brought in assets, took care of marketing, etc.  In other words, while Taylor relied less on his old firm’s investment personnel, he still benefitted from the infrastructure and the lack of responsibility of having to run the business.

On the other end of the spectrum, Brad Radin was one of nearly three dozen investment professionals supporting the management of all Templeton-branded equity funds.  Among the 30+ investment professionals was a handful of global small cap specialists that assisted Radin in running the Templeton Global Smaller Companies fund.  While he has hired a portfolio manager and analyst to help him, there is a question as to whether Radin can replicate the kind of support system he previously enjoyed.

This is not an easy assessment to make.  And any conclusion on this front will be very subjective.  A related issue arises when a manager leaves one place and takes a lengthy break prior to resurfacing.

What if…

The recent Northwest Ethical announcement is an interesting study in this regard.  Christine Hughes left AGF and her lead manager duties on the AGF Canadian Asset Allocation fund in January 2010.  In April 2009 – almost a year before her departure – Hughes made a number of clear statements pertaining to her outlook and associated portfolio positiong (which I’ve paraphrased below).

Notes from 02-Apr-2009 conference call

Market Outlook

  • We’re still in a bear market and this rally is a dead cat bounce.  There are many shenanigans going on and banks are not lending.
  • The Great Depression saw six strong rallies before hitting bottom. Every time it bread new optimism only to be disappointed later.
  • But this rally has lots of legs. Saw this coming as the “internals” (i.e. advance/decline, up days vs. down days) were pointing to an upside even though the overall market was falling.
  • The cliché of ‘sell in May, go away’ probably will hold.

Portfolio Positioning

  • In early April 2009, the fund held 40% in bonds; 30% stocks; and 30% in cash.  Short position on the S&P 500 was closed a month earlier.
  • Bond duration has been extended to eight years, with an almost exclusive focus on government bonds.  Stocks are mainly focused on golds and energy.
  • Did not see the weakness in energy coming in 2008 but there is a huge forward-looking opportunity in energy stocks today.  We’re coming into a seasonally weak time (May), which should result in a sell off.  But by early 2011, those who don’t buy energy during the spring and summer [of 2009] will be kicking themselves.
  • Bought Canadian financials (e.g., Manulife & TD) but plans to sell when the rally is over.

Hughes left AGF nine months after that conference call so there is no way of knowing what would have happened had she stayed.  In those subsequent nine months, her fund was flat while her peers enjoyed double-digit gains.  The advantage of her stellar bear market performance – Hughes’ fund lost just 11% in the 2008-09 bear, less than half of her peers’ average loss – eventually vanished as the AGF fund’s bearish positioning missed most of the recovery – before and after Hughes’ departure.

My point is that she will get all of the credit – and rightly so – for her fantastic bear market performance, but the fund’s current manager will likely shoulder all of the blame for the fund’s flat performance during the recovery – when it should be shared.  And Hughes has no audited track record since her departure two years ago so there is no way to know how she would have performed.  This makes performance evaluations tricky.  But it also skews observers into giving managers in Hughes’ position arguably more credit than is due.

I don’t mean to pick on Hughes.  I think she’s a refreshingly bold money manager.  But I detail all of this to highlight the biases that are likely to exist today as she takes over her new Ethical mandates; and to touch on the challenge of assessing a manager’s skill in a new ‘environment’.

I also raise these issues in the hope that investors and their advisors won’t let their fond memories of any manager result in setting unrealistic expectations.  Business risk and ‘ownership’ of past performance – and the future and continuity thereof – must be thoroughly scrutinized prior to getting too comfortable with these winning managers in their new businesses.