Portfolio managers, advisors and investors alike were relieved to close the book on 2008 and look forward to a hopefully better 2009. Unfortunately, the impact of the year’s market will linger long after portfolios have recovered. One lesson learned is that when we look at investment managers over the next decade, we will need to place greater emphasis on the qualitative aspects—as well as the quantitative—since these will be more indicative of long-term quality.
Whether up or down, large market swings can easily distort the returns-based quantitative analysis of investment portfolios. When the market dropped 22.43% in the final quarter of 1987, the long-term performance numbers of the major indices were impacted in a very obvious manner. But the long-term impact could only be seen in retrospect. As the graph below illustrates, the five-year return of the Russell 1000 at the end of 1992's third quarter—which includes the ‘87 crash—was 9.14%. But just 90 days later, at the end of the fourth quarter—which did not include the crash—the five-year return jumped to 16.27%. Similarly, the 10-year return at the end of third quarter 1997 was 14.77%, but jumped to 18.07% just 90 days later. The impact will be very similar over the next decade. The Russell 1000 was down 22.48% in the final quarter of 2008 and 37.60% for the year. Not until the five-year numbers are calculated at the end of 2013 will 2008 really be put to rest.
From a quantitative standpoint, the expected substantially higher volatility over the next several years has implications for advisors and portfolio managers using current return and volatility measures to project future returns through Monte Carlo or other simulations. In fact, as of the end of the year the 10-year return on the S&P 500 is negative (despite only four years with negative returns), and the standard deviation is 16.90%. Long-term projections based on these figures would always see clients losing money!
We believe that for the next several years due diligence efforts should emphasize key qualitative characteristics such as a firm’s organizational strength, the tenure and experience of key investment professionals (including the research and quantitative teams), and the manager’s particular investment process. One critical issue facing many investment management firms is the loss of assets under management—the key driver of firm revenues. Between losses of over 30% for the year and withdrawals of capital, some firms might see 2008 revenues down by 40% or more. This, in turn, will force those firms to cut costs by reducing staff, marketing, and possibly closing less profitable products. As a result, understanding the total firm picture—ownership, asset flows, business plan going forward—will remain crucial to evaluating long-term stability.
Similarly, evaluating the investment professionals responsible for managing a particular product will reveal whether the team has the ability to execute its strategy—especially true for firms that are forced to cut staff. The management team’s record also inspires confidence that they have been through similar markets before and know how to adapt and persevere—a significant advantage for the next several years.
Finally, understanding both the overall strength of the investment firm, as well as the ability and personality of the portfolio management team, leads to a better understanding of the product’s investment process and how that
process should hold up in coming years.
J. Gibson Watson III is president and CEO of Prima Capital, a Denver-based firm that conducts objective, institutional-quality research and due diligence on SMAs, mutual funds, ETFs and alternatives. www.primacapital.com