Good performance and a strong brand name you recognise may be strong starting points for many novice investors when picking funds, but make a “terrible” way for institutions to invest, according to experts.
Yet the belief is that these large institutions are just like the rest of us. Indeed, a survey by PR firm Edelman Smithfield of 300 investors in the US and Europe found that most thought institutional investors prioritised a strong brand and past performance as the top two reasons why asset allocators give their cash to certain strategies.
Patrick Race, managing director at Van Lanschot Kempen, said investing in this way would be an “absolutely terrible idea”, branding it as “nonsense”.
“On brands – there have been some really big brands that have completely disappeared. I don't want to name names but we can all look back to the dot-com times and the big brand investment management companies then simply don't exist anymore,” he said.
“And when I think about track records, I think, well, past performance isn’t necessarily a guide for the future. So again, that would probably fail.
“If I'm Joe Bloggs on the street, finding someone I recognise and someone who's done alright is clearly a good idea. But the way that we do it as fiduciary managers and as investment consultants is much more sophisticated than that.”
Niall O’Sullivan, global solutions chief investment officer at Mercer, agreed that this method of fund selection is more akin to retail investing, as a strong brand and good performance “would attract people in”.
However, he noted that at the more institutional end of the market, companies have to be more nuanced.
Rather than a strong brand, he said a strong management team is more important, as this enables people to be the best investors they can be at any given firm. “That does matter,” he said. But a strong track record has to be taken with a “real degree of caution”.
O’Sullivan used the example of private credit, which has been a “very good, interesting place to invest” over the past few years.
However, there has been no stressful credit event since the 2008 financial crisis, meaning it is difficult to know what will perform well when conditions become more difficult.
“There were some bumps around Covid, but the authorities stepped in to fix it very quickly. So the type of firm that is likely to do well if we get some sort of economic slowdown is the one that's likely to be doing, relatively speaking, a little bit worse at the moment,” he said. For him, investors should look at funds that are adding protection, lowering risk and being more strict on covenants.
What are institutional investors looking for?
Race said he looks for teams that can demonstrate persistent skill, which involves understanding how they deliver their performance. This, however, is “a hard piece of work to do”.
Rather than looking at past performance in a vacuum, he noted that track records need to be assessed over a variety of different time periods. This allows him to look at how the strategy works in different conditions.
Like O’Sullivan, he said a strong management team was important, while one overlooked aspect is the ability for the manager or representatives from the firm to accurately and coherently explain what they do and how they invest.
“If they can't tell you how they're investing, I'll run a mile. And their degree of honesty as well. I hate it when managers say, ‘ this is how I'm performing, this is going to happen forever’, because that's clearly not the case,” he said.
“There's a subtlety in the relationship – there’s management that needs to come into this. And it is really hard to do.”
At times, he uses consultants to help, while if he cannot find an active manager he is comfortable with, he will go passive, which involves looking for tracking accuracy and fees.
Peter Smith, investment director at TPT Retirement Solutions, agreed that transparency is a key thing institutions look for when handing out mandates, noting that this can be particularly difficult in places such as the emerging markets or in complex asset classes where “you don't get transparency”.
He added: “The best way to do that is at the outset – asking the right questions and then consistency: do they do the thing you expected them to do?”
He said institutions should have a set of beliefs about what type of manager can add value, which will be different depending on the asset class, and should take time to understand how returns are generated.
“What might suit, say, a long-only active manager, may not suit a credit manager. So you might need to use different platforms, different skill sets and different business models,” he said.
An example of this would be a value manager. The style of investing has been out of favour for much of the past 15 years and, as such, we would expect a manager using this process to underperform.
“It should be our decision as an allocator, not their decision in terms of style drift. If the style doesn't work, we will make the decision to move away, not expect the manager to necessarily do that for us.”