Five questions to get to brass tacks with your money manager

CHICAGO Fri Mar 22, 2013 9:30am EDT

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Four thousand U.S. dollars are counted out by a banker counting currency at a bank in Westminster, Colorado November 3, 2009.

Credit: Reuters/Rick Wilking

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CHICAGO (Reuters) - When interviewing a money manager, most investors want to know investment performance. It is a natural question, but there is much more you need to know beyond absolute returns.

In lieu of focusing exclusively on annual performance, it will be more important to know about a money manager's record on capital preservation and expenses.

Anyone can do well in a bull market and many have lucky years. But when you are looking for a money manager, you want to find out what capacities he or she has beyond that - what makes them earn the fee? Here are some questions that will help you get beyond the surface:

1. How well do you do against a standard index, not just absolute returns?

A manager's relative performance, when judged against a specific index, is different than the absolute return, because it lets you know how he or she fared relative to a benchmark. But if you ask this question, the manger can really fudge the numbers, so you have to be sure to press for specifics.

You have to choose an index that matches the style and market capitalization strategy being employed. For instance, if the manger primarily invests in large-company U.S. stocks, you should see how the record compares - after expenses of course - against the S&P 500 Index.

There are also mid-cap, small-cap and micro-cap indexes and those for growth- and value-oriented (picking bargain stocks) managers. U.S. bond portfolios should be measured against the Barclays Capital US Aggregate bond index. Global stocks generally are gauged by the MSCI EAFE index.

Most managers will not beat an index over time, which is why you may be better off with those who create portfolios for a flat fee and place you in low-cost index funds from the Fidelity, DFA, iShares, Schwab or Vanguard groups.

2. What's your "downside capture ratio"?

This will really throw managers for a loop, since most clients do not ask for this. This number tells you how well a portfolio does when a benchmark index such as the S&P 500 declines. If it is 100, that means it follows the index down 100 percent.

If it is less than 100, it is more desirable if you want more downside protection. Conversely, the" upside ratio" gives a rating when the market rises. If you are looking for capital preservation as a prime reason for choosing a manager, then the downside ratio is more important. If you are flummoxed by this jargon, then just ask mangers how their stock funds performed in 2008. If they lost just 20 percent - compared to a nearly 40-percent hit for the S&P 500 - then that is a good sign. Ideally, they should have a low downside ratio and high upside ratio.

3. Are they worth the fees?

Most money managers are not. A rule of thumb is that most of them charge 1 percent annually for assets under management. As your money hopefully grows, so does their compensation, although they may be doing little or nothing special to earn their keep. They generally lower the fee the more funds you place with them. Here is where you have to be careful: Some may charge you commissions for buying stocks, bonds and other securities in addition to the annual fees while some may just charge a flat rate for setting up an all-index-fund portfolio, which makes the most sense to me.

Even if you think you can save money by setting up you own account and trade through an online discount broker, you still may get nailed by fees. The holder of your account could be including mutual funds in your portfolio that have 12(b)-1 fees for marketing, commissions, fund management or revenue-sharing. All of the expenses eat into your principal.

In any case, ask for a complete disclosure of all compensation and fees, which is available by reading their Form ADV, Part II. They should gladly provide this form or you can obtain it through the SEC (www.sec,gov/divisions/investment/iard/iastuff.shtml).

4. Do they have any conflicts of interest?

Many money managers do, but these should be detailed on Form ADV, Part II. I would also run a background check through state securities regulators (find them at www.nasaa.org). You want to know if the manger had any serious complaints, disciplinary or legal actions lodged against him or her.

5. What do you want them to do?

You have to be realistic. Most mangers will not be able to consistently beat market indexes. Those that claim otherwise get you into Madoff territory. One way to measure overall skill is to ask for their "alpha," which is a measure of excess returns over a benchmark. A "Sharpe ratio" is also an important gauge of risk-adjusted performance - the higher the better. A positive alpha shows the manager is beating a benchmark.

While you are likely to find managers who are well-versed in protecting capital, you also need to know what kind of support they offer. Will they spend time writing an investment policy statement that matches your risk tolerance and goals? You will need one if you do not already have one. Will they rebalance your portfolio on a regular basis to reflect those guidelines? Managers offering comprehensive services like these are often registered investment advisers, certified financial planners or chartered financial analysts.

Ultimately, though, it may come down to whether you trust a manager to carry out your portfolio mandates.

One friend of mine, who meticulously reviewed several managers and showed me their documentation, chose a manager because he thought he would manage his money well after he died - so his wife wouldn't be worried about that. Although I told him the manager charged too much, he went with him anyway. You can never discount the trust factor, but you don't want to overweight it, either.

(The author is a Reuters columnist and the opinions expressed are his own. For more from John Wasik see link.reuters.com/syk97s)

(Follow us @ReutersMoney or here Editing by Beth Pinsker and Kenneth Barry)

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