When you invest, you perform your due diligence to pick the best businesses, run by able and shareholder-oriented management. But if you choose to hire someone to invest for you, you should put that same degree of analysis and due diligence to work on selecting your investment manager.
There are at least as many investment managers as there are publicly traded stocks. That bodes well for investors, who can -- and should -- carefully examine all of the options available to them. With as much care as if they were selecting a stock, investors should seek out investment managers whose interests are completely aligned with those of their investors -- including a focus on creating long-term value.
Yesterday, I pointed out that your most obvious considerations in picking a manager should be that manager's personal stake in the fund and the fund's fee structure. Today, let's dig into these two factors a bit more.
If a top chef refused to eat at his or her own restaurant, you probably wouldn't dine there. You should apply the same approach to investment managers. After all, if prospective investment managers don't eat their own cooking, then why should you?
I see no flexibility in this test. If investment managers are confident in their ability over the long haul, they should happily be willing to invest all of their available assets into their own products. It's rare to find investment managers who have the bulk of their wealth under their own control yet fail to create value over a meaningful period of time.
Perhaps the most amazing example of this owner-oriented philosophy is Warren Buffett's Berkshire Hathaway
Winners all around
When a manager's fortunes move in lockstep with those of his or her investors, the end result is usually favorable for everyone involved in the long run. Costco
Yet it's up to you to do your own due diligence, to discover whether a manager passes the test. The work will pay rewards, since, in the asset-management world, a little digging can reveal some excellent candidates. If mutual funds are your choice, look no further than Benjamin Graham disciple Mason Hawkins and his Longleaf Funds, or Bruce Berkowitz and his Fairholme Funds, or Marty Whitman's Third Avenue Funds. You will find some common characteristics among all of these funds: high levels of insider ownership, straightforward communication, and excellent long-term performance. In fact, at Longleaf, insiders aren't allowed to invest outside the company's funds.
The private investment world, which includes hedge funds, also boasts some fantastic choices for long-term-oriented investors. My favorite example is the Pabrai Investment Funds, run by Mohnish Pabrai. His funds are nearly identical replicas of the original 1950s Buffett Partnerships. Pabrai charges no management fees until his funds deliver at least a 6% return to his investors, and like Buffett, Pabrai has the vast bulk of his family's wealth invested in the funds.
Another private manager worth watching is Mark Sellers at Sellers Capital. Sellers uses a more traditional fee structure, but his phenomenal performance over the past five or so years, coupled with the value he has created for his investors, entitles him to every single penny of his fees. My friend and fellow Fool contributor Emil Lee has had the opportunity to interview both Pabrai and Sellers.
Keep it simple
You would avoid investing in companies with excessive debt or no long-term earnings power. In the same way, applying a couple of simple filters in choosing an investment manager will eliminate a lot of poor performers. After you find the managers whose interests are aligned with those of their investors, your next step is to pay attention to costs -- the topic of my next article.
For now, I'll leave you with a comment from Buffett. When some MBA students asked him whether he would invest in a hedge fund, this is what he said:
Yes, if a 30 year old ... was running it, and they had all their money and their families' money in it and were sharing the downside. I have no complaint with incentive pay for hedge funds; I just want to make sure the person running it is as committed as his partners. ... You can occasionally find small groups of bright people who can do well over time. These people will be distinguished much more by temperament than IQ. You want to make sure that these people treat your money like it is their own.
Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership operating in similar fashion to the 1950s Buffett Partnerships. Sham eats only his own cooking and always will. He has a stake in Berkshire Hathaway. Costco is a Stock Advisor recommendation. The Motley Fool owns a stake in Berkshire Hathaway, which is also a Stock Advisor recommendation. Fairholme Fund is a Champion Funds pick. The Fool has a disclosure policy.