To help uncover a solid performer, follow these selection criteria

By Michael Nairne | August 2017

As financial advisors pour billions of dollars into index-based ETFs, the use of active managers in portfolio construction increasingly comes under question.

The evidence is clear: as a group, active portfolio managers underperform their benchmarks by approximately their costs. Second, manager outperformance generally is not persistent, so selecting managers based solely on past performance is little better than a roll of the dice.

Yet, a skillful few portfolio managers clearly can be successful in selecting winning active portfolios. Take Yale University's endowment fund: its U.S. equities portfolio has earned a 12.3% annual return over the 20 years ended June 30, 2016.

This track record handily surpasses the returns earned by a broad range of funds managed by several U.S. index and enhanced index portfolio managers during the same period. The Yale U portfolio's return also beat the majority of "smart" beta indices.

So, although the odds are stacked against you, the pursuit of superior returns by attempting to pick winning active portfolio managers is not a hopeless quest. By using a range of selection criteria that go beyond return performance, you can improve your chances of success

- Low costs are Job 1. Studies by Chicago-based Morningstar Inc. repeatedly find that the single greatest predictor of a long- only manager's ability to beat a benchmark over longer time periods is the management expense ratio. Enthralled by the tantalizing short-term returns of some expensive funds, many advisors forget this critical lesson.

- Several studies have found that high employee ownership and low employee turnover are associated with superior performance of portfolio-management firms. Experienced, stable investment-management teams composed of long-term owners tend to outperform employee-dominated firms.

One study also found that privately owned investment firms tend to deliver superior returns vs publicly owned companies.

- Significant investment by a portfolio manager in his or her fund is associated with stronger performance.

When portfolio managers have a sizable piece of their net worth riding on their decisions, their interests are more aligned with those of fund investors. These managers also arrive at work every day with a dual motivation for seeking superior risk-adjusted results.

- Smaller generally is better. Although an investment organization needs sufficient scale for operational stability, risk management, proper research and ongoing investment-process improvement, fund size becomes the enemy of outperformance.

Portfolio managers of smaller funds have greater capability to invest in smaller, less liquid companies - a segment of the overall market that traditionally outperforms.

Portfolio managers of smaller funds can build and exit large positions in companies faster and with less price impact than on their larger counterparts. Of course, size is relative: the US$48-trillion global stock market offers enormously more scope for a large fund than the US$225-billion Canadian small-cap market.

- Specialization also is associated with superior performance. One study found that investment firms with fewer funds generally outperformed larger organizations offering a supermarket of funds. A focus on asset gathering over investment-management expertise is deleterious to performance.

Having said all that, you can best serve your clients by building their portfolios with a foundation of low-cost index funds. Active portfolio managers should be added only if you are prepared to assess them using a comprehensive range of criteria that go far beyond returns.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.

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