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Judging the book and its cover

Product evaluation has two layers

My opinions on mutual funds or other products are sometimes challenged based on either a product’s structure or perhaps the skills of the money manager behind the product. The saying, “don’t judge a book by its cover” comes to mind. It doesn’t exactly apply to financial products but it’s related. Evaluating a product’s investment merit requires a separate but integrated analysis of the underlying core investment (and manager) and the structure or “cover” within which a manager’s skills are packaged.

The book

I equate the book to the contents or – in the context of financial products – the skill of the portfolio manager at the core of the product. This is evaluated using numerous quantitative and qualitative factors – with my emphasis tilting toward the latter. Quantitative comparisons, while seemingly simple, should be done very carefully. Many public data sources don’t list a suitable benchmark for a particular product. (See my previous article on Benchmarking Problems for more on this topic.) Further, some products have no suitable benchmarks against which to compare performance to gain historical insight.

Also, no product’s historical performance – in and of itself – is likely to offer stand-alone proof of manager skill. The reason lies is basic statistical concepts pertaining to return distributions and the range of returns due purely to random chance. In short, there is no money manager I know of whose length of track record and amount of outperformance (over a suitable benchmark) offers such statistical proof. This is the reason that serious fund-picking efforts must blend in a healthy dose of qualitative factors.

Qualitative analysis involves a detailed list of questions on the investment process and an evaluation of its potential to live up to the sales pitch going forward. Must easier said than done – a big understatement – but that summarizes the approach. If a sufficient level of qualitative analysis is not done (properly), you’re better off indexing, which many academics feel is the better route no matter what type of analysis is done.

All of this notwithstanding, let’s say you decide that a particular manager stands apart from the rest. You’re job is only half done.

The cover

While it is a key requirement, a good manager does not single-handedly make a good investment product. The structure within which a manager’s skills are packaged is the other half of this equation. Most notable of structural issues is ‘cost’. What’s a good manager worth? What’s the best manager worth? Let me be more direct.

Would you pay 10 percent per year for Warren Buffett? Would you pay 5 percent annually? It’s easy to look in the rear view mirror and state what he was worth in the past. But the answer today has to be based on a forward-looking assessment. It’s not easy and the right answer can only be confirmed in hindsight. However, we know that both implicit and explicit fees do have a certain, mathematical impact on future performance – no matter what the product. While costs are just one structural component, they are more important than most advisors (and the industry) admit.

Other structural issues could have legal, tax, and other implications. For instance, a segregated fund allows the policyholder to designate a beneficiary on a non-registered policy. This has some value that may go beyond pure financials, within reason. Another example is a corporate class mutual fund, which provides a tax-efficient way of rebalancing and usually reduces distributions from year to year.

Structural features often have implications that are very specific to an individual client. The costs embedded in the structure (and the excess cost over that of another similar alternative) must be compared against the benefits provided. In a more objective context, the core investment product (“the book”) can be evaluated on its own.

At the end of the day, both quantitative and qualitative factors should be applied to both the core investment and the structure wrapped around it, in order to make a fair and complete assessment. Simply doing half the job doesn’t bode well for the quality of your counsel to your clients.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at


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