Inside Colonial First State's fund manager selection overhaul

Colonial First State (CFS) managed the two best-performing MySuper options over the year to March 31. The wealth management and superannuation provider's head of equities Ben Lam explains the "art and science" behind its recently evolved manager selection process.

CFS, which manages all equity exposures externally, assessed what it believed is the best way to manage portfolio risk around three years ago - about the same time its chief investment officer Jonathan Armitage joined and roughly a year after one of its funds failed the inaugural Your Future, Your Super performance test.

Lam told Financial Standard that the team identified "a lot of unintended risk" from concentrated, very benchmark-agnostic approaches, prompting what he described as a "clipping of the wings."

CFS previously had managers who invested in narrow parts of the market and didn't use the full opportunity set available, he said. Now, it has more managers who assess the market in its totality, at least from a risk management perspective, and are more open to investing in all types of stocks.

For example, he cited a deep value manager, previously in the portfolio, whose performance profile was one where "when they perform well, they perform extremely well," however, its returns were "very sporadic" and extremely dependent on market conditions.

"They might have one in five years or one in seven years of outperformance," he said.

"All their outperformance came from a single year. To us that wasn't a desirable alignment to our own objectives of delivering consistent performance over rolling three-year periods."

He said that many of CFS's current managers have "a few more degrees of freedom" than those it's used in the past, whose fishing pond was in very narrow segments of the market, whether on the value or growth side.

"The ability of our managers to fish across the market spectrum gives additional flexibility," he said.

While Lam doesn't believe there's a perfect model for assessing managers, he explained CFS has always considered a range of factors that, when listed, seem like common sense.

But CFS now assesses these factors within a framework to ensure a level of repeatability.

That's evident in how CFS evaluates fund managers' past performance, recognising it as a "critical element" albeit the usual disclaimer that past results don't guarantee future ones.

The firm considers not just the returns themselves, but the insights they illuminate about a manager's reaction and behaviour across different market environments.

Lam said another important aspect is alignment - not just from a performance perspective, such as how much skin in the game a manager has, but also a close alignment with CFS's objectives.

Lam said of one of the interesting things the team has been thinking through is how they're tasked with outperforming a benchmark - specifically, his role in assembling a portfolio of equity managers across Australian shares, global shares, and emerging markets.

While one-year performance is very hard to consistently outperform, a three-year horizon is seen as "a more reasonable and achievable objective from a multi-manager perspective."

What unfolds next, he said, is that many strategies have long investment time horizons, raising the question of whether they align with internal objectives.

"... you could have a strategy that, if you had a long enough time horizon, is really great, but the expected delivery of performance could be over a seven or 10-year period," he said.

"We've seen that with value. That's one of the areas we've dialled down because a lot of value managers rely on market conditions to deliver their outperformance.

"It's been a pretty horrible period for value managers since the Global Financial Crisis."

The team has also tried to minimise "filling buckets for the sake of it." Historically, CFS would pair a growth manager with a value manager to create balance, but that approach "works until it doesn't" because correlations across asset classes and managers are "inherently unstable," he said.

That's the "overarching aspect," but the key point, he continued, is that the team uses several risk systems and tools to help form its opinions, because "the numbers don't lie."

He said that, particularly in the global equities space, while still taking "lots of active risk" with high return potential, there's more embedded risk controls in manager selection.

This has been done so that CFS's managers have greater alignment with the benchmark, though that's not to say that they're benchmark hugging.

"One of the aspects we found has helped us as the market became more concentrated and the artificial intelligence thematic was really playing out - an emerging risk apparent to many of our managers - [is that] they were able to adapt... as opposed to the narrative of, 'the market's changed, but my process isn't adaptive to market changes,'" he said.

CFS's playbook for hiring and firing fund managers

In the year to December 2024, not-for-profit funds awarded an estimated 62 mandates, down from 148 in the previous year, according to Rainmaker Information.

For comparison, around 2000 mandates were awarded over a rolling 12-month period to December 2010.

This decline is indicative of funds managing larger portions of their investment portfolios in-house.

Other analysis from the research house in January 2024 found that 17% of APRA-regulated superannuation funds under management (FUM) was internally managed in 2023.

It projected that figure could grow to 43% over the next two decades, which would mean even more institutional mandates would be choked off from fund managers.

CFS, while a retail rather than not-for-profit fund, is presumably a garden of Eden for the countless fundies whose business models have come under siege as more funds internalise.

Lam, when considering a new manager, said one of the key things is being open to as many meetings and engagements as possible: "Sometimes you just have to kick the tyres."

He said that while CFS might gain a great deal of confidence and rapport with an incumbent manager over time, it's necessary to remain open to change.

The next step, Lam explained, is considering whether a prospective manager is similar to an incumbent in its process and approach. If they are, he must have greater confidence in the new manager versus the existing one. Alternatively, he might look for a manager offering "something unique," differentiated ideas and return streams that embed diversification.

"... because I'm not filling buckets, I know managers will be correlated at a certain point, and that's inevitable. But if I think a manager offers something differentiated, it gives me a trigger to look at them a little more closely. That's when the quant comes in," he said.

"We might then engage with the manager to look at their holdings and performance to ask: 'Is this a differentiator to an incumbent' or, in the case where there are similarities to an existing manager, 'Is something differentiated or special about it relative to an incumbent.'"

Lam added that "there's no shortage of managers who'll reach out to us," but just as they hustle to land mandates with CFS, there are clear reasons some are shown the door.

Underperformance alone isn't a reason to sack a manager, he said. It's more about whether their poor results conform to expectations.

For instance, a deep-value manager would've been expected to underperform for much of the past decade, which in itself "isn't necessarily a reason to fire a manager," he said.

The trigger, he explained is the fund's evolved approach to portfolio construction.

Another aspect, he clarified, is how gradual changes - an analyst departure here or there, another six months later - can quietly add up. If half a team turns over within a few years, that dynamic sparks "cause for concern" about whether deeper cultural issues exist.

Though, "to be fair to managers," he said turnover can be "perfectly valid." From the perspective of keeping a manager, one that's willing to weed out those who don't fit their approach and philosophy has merit, he added.

He also said corporate change is always a big issue.

"You almost know that with a new chief investment officer or portfolio manager, that even though they can be well telegraphed, the underlying changes can be significant," he said.

"Often, a new portfolio manager, in putting their own stamp on things, might start to deviate from some of the reasons why we appointed the [fund] manager," he said.

Business risk, too, is an important element of the equation.

"Sometimes we're happy to be early backers of fund managers because that's often when you can get good returns. But at the same time, if they don't catch on and build a business, the distraction of business management versus portfolio management becomes an issue," he said.

Nevertheless, despite the heightened level of change, particularly on the equity side due to the rethinking of portfolio construction and risk management over the past two years, ultimately, he said, "we want to appoint our managers for the long term."