When hiring an investment manager, past performance is one of the most important factors to consider. For this reason, many investment managers maintain a composite, which is an aggregation of portfolios they manage that represents a specific investment mandate. Composite presentations give potential investors insight into the past performance of an investment manager's strategy. The direct marketing of investment management services has increased the need for individual investors to be familiar with the ins and outs of composite presentations. Read on to learn about some of the terms used in composite presentations and what professional investors look for when analyzing these terms.
Example Composite Presentation
There are many different ways to display composite performance, but preparing and presenting a composite presentation in compliance with the Global Investment Performance Standards (GIPS) is the "gold standard." Below is an example of a composite presentation.
Figure 1: Example Composite Presentation
Composite presentations, like the one displayed above, give investors the opportunity to assess the quality of an investment manager's performance numbers. Below are five points that need to be considered when looking at an investment manager's composite presentation.
- Gross-of-Fee and Net-of-Fee Total Returns
Composite presentations will typically display both gross-of-fee and net-of-fee total returns. A copy of the investment manager's fee schedule should be requested if the composite displays gross-of-fee returns only. You should be wary of composite presentations that only show net-of-fee returns. The composite could include one large portfolio that pays little or no management fees. This could enhance the composite's net-of-fee return if it is asset-weighted. The best way to compare the investment returns of one manager's composite versus another's is to use a gross-of-fee return and subtract the fee that would be applied to your account.
Composite presentations should include the investment benchmarks total return for all periods shown. It is important that the investment benchmark is clearly defined and that its definition matches the composite's investment strategy. Be cautious if the composite's investment returns have a low correlation with the benchmark's return. This could signal that the investment strategy is not being employed properly or that it does not match the intended benchmark.
- Number of Portfolios and Total Composite Assets
The total number of portfolios and the total assets invested in the composite should be displayed. You can use this information to figure out the composite's average portfolio size by dividing the number of portfolios into the total composite assets. Sporadic changes in the number of portfolios could signal that the investment manager's definition of a discretionary account is too narrow or that the manager has high client turnover. Large increases in the number of portfolios or total assets in the composite may signal future operational or investment strategy implementation issues. For example, an investment manager may need to add more staff to handle the client service issues associated with managing more portfolios, or may grow too large in size to employ the intended investment strategy.
- Internal Dispersion
The annual internal dispersion of the composite should also be displayed. It is a measure of the variability of portfolio-level investment returns in the composite over a given time period. Internal dispersion is important in analyzing an investment manager's ability to manage all portfolios in the composite in a similar manner. The smaller the dispersion measure, the more consistent the returns are across the portfolios in the composite.
- GIPS Compliance, Verification and Other Disclosures
If the investment firm is in compliance with GIPS, there will be a disclosure on the presentation to this effect. Although not required, many investment managers hire GIPS verification firms to assure investors that they comply with the standards. If that is the case, it will also be disclosed. In addition to GIPS compliance and verification, investors should also look for disclosures including, but not limited to, a definition of the firm, a definition of the composite, the investment manager's fee schedule, the total firm assets and a statement regarding the availability of the investment firm's policies and procedures for calculating and reporting investment performance.
The different measures of dispersion can include, but are not limited to, high/low, range and standard deviation. The high/low measurement presents the highest and lowest performing portfolios in the composite. The range measurement is the difference between the highest and the lowest performing portfolios in the composite.
For example, if the highest performing portfolio in a composite returned 12% and the lowest performing portfolio in a composite returned 8%, then the range measurement would be 4%. The standard deviation of the portfolio-level returns in a composite can also be used as a measure of internal dispersion. It can be calculated by equal weighting or asset weighting the individual portfolios in the composite.
The Bottom Line
Looking at the investment manager's past performance numbers alone is not enough. The true quality and predictability of an investment manager's performance lies in the details of their composite presentation and their investment philosophy. Being familiar with the terms and details of composite presentations will give you insight into the true quality of the investment manager's performance and help you separate skillful investment managers from lucky ones.
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