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How long an investor should wait before parting company with an underperforming asset manager is an age-old question in the institutional investment arena.

For some, the answer to that question is never, while others suggest investors should consider dumping their fund manager at precisely the point at which they are beginning to shine.

“It is the one question we are asked most by our clients, but unfortunately it is also one of the most difficult to answer,” says Craig Baker, global head of investment research at Towers Watson, which counts some of the largest institutional investors among its roster of clients.

Difficult or not, figures clearly show that investors are ditching their asset managers in large numbers with the BBC’s pension scheme, Denmark’s Industriens Pension, and Electrolux’s group pension fund just a few of the many institutional investors to terminate contracts with their respective fund managers over the past few months.

Whether or not these terminations came at the right time, however, is harder to ascertain. “The merry-go-round of manager changes can often be nothing more than the futile chase for the next rainbow,” says Amin Rajan, chief executive of fund consultancy Create Research, who believes investors need to engage more with their managers to find out the “source of mediocre returns before considering a switch”.

“Today’s markets are moved more by politics than economics and most price movements constitute ‘noise’ rather than ‘signal’. Replacing an underperforming manager is a tough call to make.”

The trick, according to experts, is to assess whether a dip in performance is down to poor skill rather than bad luck or bad timing.

“Performance is not a necessary or sufficient condition to fire a manager, however bad that performance is,” says Towers Watson. “Only when past performance is clearly happening alongside a loss of skill or a failure of risk control do we reach the point of no return.”

Debbie Clarke, global head of Mercer’s equity boutique, agrees. She says the issue of when to fire an underperforming manager is one of her firm’s “greatest challenges”, adding that key questions must first be asked to understand why a manager is underperforming.

“Is the underperformance as you would expect given a manager’s style, how has the manager performed relative to others in the client portfolio, and does the manager understand their own performance?” she says.

“Typically after two years of underperformance serious questions will be asked but understanding an investment manager’s expected performance pattern is extremely important as it avoids terminating an underperforming manager at the wrong point in the cycle.”

Firing a manager at that “wrong point” can be very costly according to Towers Watson. A report just recently published by the firm shows that, on average, changing managers after a three-year period of underperformance, results in lower returns than either sticking with an active manager or allocating to passive strategies.

“Retaining an underperforming manager often proves more profitable than replacing them,” says Mr Baker, whose firm modelled scenarios for an investor that sacks an underperforming manager with one that is prepared to hold tight.

“Investors react to performance more than they should and hire and fire managers based solely on this, but it is a destructive approach,” he says, adding that managers have styles that come and go and that often the worst time to get “rid of a manager is after a period of poor recent performance”.

“We in fact spend a lot of time telling clients to get rid of managers that have done very well. Although the numbers might be good at that moment, a manager might be getting expensive, becoming out of date in its style, or just simply losing touch,” says Mr Baker.

On the question of whether a consultant should compensate its client for the cost of switching away from a poorly performing manager, given their involvement in that appointment, Mr Baker says no.

“In an old fashioned beauty parade it’s difficult to argue that a consultant should compensate clients for a poorly performing asset manager. It’s a bit like saying that a doctor should get the same illness as their patient if they diagnose that illness incorrectly,” he says.

Mercer’s Ms Clarke adds: “The consultant’s role, to the extent that it is an advisory relationship, should not bear the cost of the transition. The advisory cost of a manager search is miniscule in relation to the cost of a manager’s fees. It is also a recommendation; the final decision rests with the client.”

Create Research’s Mr Rajan is not so sure. He says that in an ideal world, consultants should bear the cost when past selection decisions have failed to deliver. “This will require a more meritocratic incentive system than the one we currently have. Investors have been clamouring for one. Only time will tell if they get one.”

Copyright The Financial Times Limited 2019. All rights reserved.

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