Portfolio Construction

6 factors to help improve manager selection

Vincent Fu Greg Smith Mark Barile

October 24, 2024

6 MIN ARTICLE

KEY TAKEAWAYS

  • Many advisors may be missing key criteria when selecting fund managers
  • Advisors most often overlook downside capture, which has been helpful in the long term through periods of significant volatility
  • Incremental changes can have a major impact on long-term portfolio success

Many advisors look at risk and return statistics when screening and selecting fund managers, according to the Capital Group Portfolio Consulting and Analytics team. Advisors tend to focus on rankings — which funds had the best returns, especially over shorter term periods. But what factors might some advisors be missing when it comes to long-term portfolio success? Our portfolio consulting and institutional solutions teams have met with thousands of advisors and reviewed even more funds through multiple time periods over the years. Here’s what they’ve found has historically led to stronger portfolio outcomes, especially through periods of significant volatility. 

Choosing the right manager screens can make a difference over the long term

 

Senior specialist Vincent Fu and others on Capital Group’s Institutional Solutions team have drawn from decades of research on portfolio analytics and met with many clients looking to assess their manager selection criteria. What they’ve found is that six factors stand out when it comes to results, with three rising to the top of the list: low expenses, manager ownership and downside capture. 

Six factors have been associated with better results

Table shows a list of primary and additional screens, with one column for why it matters and another column for screening criteria. First under primary screens is downside capture. Why it matters is downside resilience is a key to strong results via better risk characteristics. Screening criteria is funds that spent a majority of rolling periods in the best two quartiles of downside capture vs. peers. Next under primary screens is low expenses. Why it matters is less cost lowers the hurdle to achieving strong investment results. Screening criteria is funds within the lowest quartile of expense ratios vs peers. The last item under primary screens is manager ownership. Why it matters is managers should have a personal stake in outcomes. Screening criteria is top-quartile measures of manager ownership at the firm level. Under additional screen the first item is privately held. Why it matters is public ownership can distract and create a short-term focus. Screening criteria is large, privately held investment management firms. Next additional screen is survivorship. Why it matters is fund closures are disruptive for investors. Screening criteria is large fund families in the top quartile of survivorship. The last additional screen is long-term orientation. Why it matters is managers should align with a long investment time horizon. Screening criteria is low portfolio turnover and manager compensation that emphasizes long-term results.

Source: Capital Group. Using the first three factors greatly narrows the universe of active managers, leaving a subset that has on average delivered enhanced outcomes to investors. The remaining three factors are additional metrics to consider to help act as “tie-breakers” where appropriate. In our view, the screens also reflect an asset manager’s culture and overall investment philosophy, which we think are important considerations when choosing investments.

Secondary screens include being privately held, long-term focus and survivorship (how often a manager eliminates a fund or strategy, which can sometimes obscure unwanted results). Other factors can suggest the potential for longer term positive results such as momentum, dividend yield and geographic flexibility. But why do the top three stand out?

Downside capture crucial yet often overlooked

 

Many advisors agree that reducing risk is vital to improving client portfolio outcomes. Yet they don’t always prioritize downside capture — which measures a fund’s results relative to its benchmark during periods of market weakness.

 

“Downside capture is one of the key factors that most affects risk over the long term,” according to Fu. (Low expenses and manager ownership have tended to be stronger indicators of long-term returns.) “Down capture is crucial in time periods when there are market corrections. But it’s also commonly overlooked by advisors,” Fu says.

 

“We find that relative risk metrics are more consistent than relative return. If you’re looking for a conservative manager you could start by assessing managers with a history of attractive downside capture,” Fu adds.

 

Fu and team have found that funds that have been conservative in the past tend to stay that way in future periods. For example, a fund that focuses on dividend-paying utility companies is less likely to invest in a negative cash flow biotech company.

 

“Our screening criteria identifies active funds that have consistently generated top 50th percentile better downside capture over their history,” Fu says.

 

The screened cohorts for both the U.S. large-cap universe and the global large-cap universe had higher 10-year rolling success rates and returns versus their unscreened cohorts and their respective benchmarks for the period from January 1996 to December 2023. In general, the downside capture screen has consistently found funds that have had reduced volatility, lower maximum drawdowns and more attractive down capture, especially when combined with screenings for firm manager ownership and low expenses. 

Why screening for downside capture, low expenses and manager ownership matters

The graphic shows a U.S. large-cap universe of 2,509 active funds screened for downside capture, low expenses and manager ownership. The funnel shows that screening for the best of these three traits reduces that universe to 52 active funds. The strong downside capture screen reduced the U.S. large-cap universe to 1,027, then the low expense screen reduced that to 254 and high manager ownership narrowed it to 245. For the global large-cap universe, the strong downside capture screen reduced the number of active funds to 192; the low expenses screen reduced that universe to 96 then high manager ownership narrowed it to 93. The unscreened U.S. large-cap cohort had a 14% 10-year rolling success rate versus 52% for the screened cohort. The second graphic shows a global large-cap universe of 487 active funds screened for downside capture, low expenses and manager ownership. The funnel shows that screening for the best of these three traits reduces that universe to 51 active funds. The unscreened global cohort had a 44% 10-year rolling success rate versus 100% for the screened cohort. The return charts show that the screened U.S. large-cap universe had a 10-year rolling return of 8.11% versus 7.04% for the unscreened cohort and 7.90% for the benchmark. The screened global large-cap universe had a 10-year rolling return of 7.54% versus 6.29% for the unscreened cohort and 6.30% for the benchmark.

Sources: Capital Group, Morningstar as of December 31, 2023. U.S. Large Cap funds are those in the Morningstar Large Value, Large Blend and Large Growth categories. Global Large Cap funds are those in the Morningstar World Large Stock, Morningstar Global Large-Stock Blend, Global Large-Stock Growth and Global Large-Stock Value categories. These universes were screened as follows: Top 50% down capture filter for the U.S. large-cap universe versus the S&P 500 Index followed by cross section of top 25% lowest expense ratios and top 25% highest firm manager ownership in their fund. Top 50% down capture versus MSCI ACWI Index followed by cross section top 50% in both the lowest fees and highest firm manager ownership (given its smaller sampling size). Past results are not predictive of results in future periods. The indexes are unmanaged and therefore, have no expenses. Investors cannot invest directly in an index.  

 

1Morningstar universe of active funds uses an asset-weighted methodology. This method can increase comparability between portfolios as compared with an equal-weighting methodology. For this analysis we relied on Morningstar Direct℠ data analysis software.

2Success rates are calculated at NAV for rolling 10-year periods on a monthly basis from 1/1/96 to 12/31/23. Returns are for the same period; the S&P 500 Index is the U.S. Large Cap benchmark, while the MSCI ACWI Index is the Global Large Cap benchmark.

3Results reflect funds within the specified Morningstar category that met the combined strong downside capture, low expense ratio and high firm manager ownership screens. Not all individual funds beat their benchmark. 

Combining factors with incremental changes can add up in the long term

 

Often differences in return among the factors are small but incremental, with each screen increasing the chances of outpacing the benchmark over time. 

 

“Combining the factors is very important for long-term impact,” Fu says. “Fees help a little, firm manager ownership helps a little more. If you combine the two, it helps even more.  What I like to see is a stair step that improves your odds of meeting portfolio goals over the long term while increasing the likelihood of beating the benchmark,” Fu adds.

How incremental changes can impact long-term portfolio success

This graphic shows the impact that 50-basis-point and 100-basis-point increases in return could have on retirement savings based on the following assumptions: the investor has a starting salary of $45,000, an annual salary growth rate of 3%, an annual contribution rate of 10% and an ending salary at 65 of $146,792. If returns were to increase by 50 basis points from 5.5% to 6% before age 65, additional savings by age 65 would be $119,549. If returns were to increase by 100 basis points from 5.5% to 6.5% before age 65 additional savings would be $256,233. If returns were to increase 50 basis points after age 65 from 3.5% to 4%, the investor would have 5 additional years of retirement spending. If returns were to increase 100 basis points after age 65 from 3.5% to 4.5%, the investor would have 16 additional years of retirement spending.

*Withdrawal that produces 20 years of income in the baseline scenario, which equates to a 46% income replacement.

 

Source: Capital Group. The demographic assumptions, returns and ending balances are hypothetical and provided for illustrative purposes only and are not intended to provide any assurance or promise of actual returns and outcomes. Returns will be affected by the management of the investments and any adjustments to the assumed contribution rates, salary or other participant demographic information. The additional years of retirement spending are intended to represent a conservative measure. Actual results may be higher or lower than those shown. Past results are not predictive of results in future periods. Based on an exhibit from Russell Investments.

“There are several issues when advisors have a narrow focus,” says senior portfolio consultant Greg Smith. “Being in the top quartile doesn't guarantee a fund will stay there. In fact, focusing too much on the top funds could introduce unintended risks in portfolios,” Smith says.

 

Recent investment results can be driven by trends that are difficult to decipher until they are over.  The key risk of that approach is that investor portfolios are positioned for outcomes that have already happened. “But we can develop a framework for decision-making through periods of uncertainty,” Smith adds.

 

“Selecting good managers is a critical part of portfolio construction,” says Mark Barile, manager of the Capital Group Portfolio Consulting and Analytics team. “We encourage clients to think about their screening process as more than a view on past results, but rather a window into people, process, philosophy and durability of results.”

Want to talk through your approach to manager selection and screening?

Consider meeting with our Portfolio Consulting and Analytics team.  

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VIXF

Vincent C. Fu is a senior specialist with 20 years of investment industry experience (as of 12/31/2023). He holds an MBA from New York University and a bachelor's degree in business economics from the University of California, Los Angeles. He also holds the Chartered Financial Analyst® designation.

GRKS

Greg Smith is a senior portfolio consultant with 18 years of investment industry experience (as of 12/31/2023). He holds a bachelor's degree in history and education from Taylor University. He also holds the Certified Financial Planner™ and Certified Investment Management Analyst® designations.

Mark-Barile-bw-600x600

Mark Barile is senior manager of Capital Group's Portfolio Consulting and Analytics team. He has 19 years of investment industry experience (as of 12/31/2024). He holds a bachelor's degree in studio art from Trinity University. He also holds the Certified Investment Management Analyst® designation.

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