Emotional responses are common among managers as well as investors

Looking at a portfolio manager's track record is one thing, but understanding how he or she achieved it, and whether it can be repeated, is another story and something that financial advisers should consider when selecting funds for their clients, according to those who study investor behavioral trends. Individual investors aren't the only ones prone to knee-jerk reactions and erratic behavior during times of market stress, said Rick Kahler, chief executive of Kahler Financial Group, which manages about $135 million in assets. “Very successful, very smart people in the investment management world can be as unhinged as investors in difficult times,” he said. Mr. Kahler sat on a mutual fund board during the market turmoil in 2000 and said that the investment professionals there were anything but cool-headed. “They were as fearful and emotional as any investor,” he said. But understanding the behavioral underpinnings of a money manager's performance isn't easy. A rating from Morningstar Inc. won't tell you much and the performance numbers offer few clues as to how a manager achieved the performance or whether he or she can continue to achieve it. “Financial advisers need more insight into what skills and behavioral tendencies a manager has, and whether they stay committed to an investing process,” said Michael Ervolini, chief executive of consulting firm Cabot Research LLC. His firm analyzes portfolio managers' historical trading activities and performance to determine behavioral trends.

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Portfolio managers can fall into some of the same behavioral stumbles to which individual investors are prone. Mr. Ervolini calls one such misstep “regret aversion” — the tendency to refrain from doing something today out of fear of regretting it tomorrow. “Many managers who start building a position in a stock are slow to jump in with both feet as it goes up,” Mr. Ervolini said. As a result, they either limit the gains they can realize from their best ideas, or pay more for shares because they delay their purchases. Many other behavioral factors that can hobble a manager's performance relate to his or her willingness to sell both winners and losers in a portfolio. The “endowment effect” refers to the tendency to overvalue investments that a manager already owns and with which he or she has experienced gains. “It feels good to look at winners in a portfolio even if rigorous analysis might suggest it's time to sell,” Mr. Ervolini said. “We try to get managers to hold their older winners to higher standards.” The flip side of that dynamic is “loss aversion,” something from which retail investors often suffer. “It is core human nature to feel losses more intensely than gains,” Mr. Ervolini said. “It's difficult to admit you're holding a loser, and a lot of managers will hold them forever rather than take the loss and move on.” The objective of Mr. Ervolini's analysis is to get a better sense of where a manager achieves his or her alpha and whether they achieve it by a process that is repeatable. David Romhilt, director of manager selection at Barclays Wealth, takes a long look at managers' investing behavior before allocating money to them. He studies their monthly holdings going back 10 years in order to analyze their performance more thoroughly. “Performance doesn't mean a lot if you don't know how they achieved it,” Mr. Romhilt said. In general, he looks for consistency and a commitment to an investment process that is tangible and transparent. Mr. Romhilt also prefers managers that hit singles and doubles rather than home runs. “We'll take the home runs when they happen, of course, but we think the small victories are more repeatable,” he said. For example, in a recent search for a large-cap-equity manager, Mr. Romhilt winnowed the field down to two managers with similar performance. An analysis of their historical holdings showed that one of them was generating a large proportion of his alpha from consumer discretionary stocks, while the other was achieving his gains across multiple sectors. Mr. Romhilt chose the latter, reasoning that the manager had a greater chance of maintaining his performance on a consistent basis. His current largest holding and his “sleep-at-night fund,” is Fiduciary Management Inc.'s FMI Large Cap Fund (FMIHX). The fund company is 100% employee-owned. It doesn't take on more assets than its investing strategies can effectively manage, and it has a simple and clear investing process, Mr. Romhilt said. Mr. Romhilt considers more than trading patterns when assessing manager behavior and performance. He also looks at a firm's behavior and how the fund managers are compensated. Specifically, Mr. Romhilt wants compensation practices aligned with the manager's investment time horizon. For example, if a manager typically turns over a third of the portfolio every year, he or she should be judged and compensated on a three-year performance basis. “If a manager, on average, holds a stock for three years but is paid on an annual performance basis, the compensation is misaligned,” Mr. Romhilt said. “It might cause them to do something outside their usual investment process.” Advisers who lack the resources of a Barclays Wealth have few means to evaluate how managers behave in different markets or what their buying and selling biases are in different contexts. Mr. Ervolini hopes to fill the void. He supports 50 portfolio managers, has analyzed $600 billion worth of assets in investment funds and is in discussions with several wealth management firms about providing research to help with their manager selection process. “I look at costs, and I'm a technical person, so I look at things like standard deviations, Sharpe ratios and portfolio turnover,” Mr. Kahler said. “If there were behavioral information I could access, it would certainly be part of the equation for me.” Email Andrew Osterland at aosterland@investmentnews.com