Investment Manager Selection

Evaluating an investment manager is a complex and detailed process. It encompasses a great deal more than analyzing investment returns. In conducting investment manager due diligence, the focus is on understanding how the investment results were achieved and assessing the likelihood that the manager will continue to follow the same investment process that generated these returns. This process also entails operational due diligence, including an evaluation of the integrity of the firm, its operations, and personnel, as well as evaluating the vehicle structure and terms. As such, due diligence involves both quantitative and qualitative analysis.

This reading provides a framework that introduces and describes the important elements of the manager selection process:

• Investment manager selection involves a broad set of qualitative and quantitative considerations to determine whether a manager displays skill and the likelihood that the manager will continue to display skill in the future.

• The qualitative analysis consists of investment due diligence, which evaluates the manager’s investment process, investment personnel, and portfolio construction; and operational due diligence, which evaluates the manager’s infrastructure.

• A Type I error is hiring or retaining a manager who subsequently underperforms expectations—that is, rejecting the null hypothesis of no skill when it is correct. A Type II error is not hiring or firing a manager who subsequently outperforms, or performs in line with, expectations—that is, not rejecting the null hypothesis when it is incorrect.

• The manager search and selection process has three broad components: the universe, a quantitative analysis of the manager’s performance track record, and a qualitative analysis of the manager’s investment process. The qualitative analysis includes both investment due diligence and operational due diligence.

• Capture ratio measures the asymmetry of returns, and a ratio greater than 1 indicates greater participation in rising versus falling markets. Drawdown is the loss incurred in any continuous period of negative returns.

• The investment philosophy is the foundation of the investment process. The philosophy outlines the set of assumptions about the factors that drive performance and the manager’s beliefs about their ability to successfully exploit these sources of return. The investment manager should have a clear and concise investment philosophy. It is important to evaluate these assumptions and the role they play in the investment process to understand how the strategy will behave over time and across market environments. The investment process has to be consistent and appropriate for the philosophy, and the investment personnel need to possess sufficient expertise and experience to effectively execute the investment process.

• Style analysis, understanding the manager’s risk exposures relative to the benchmark, is an important component of performance appraisal and manager selection, helping to define the universe of suitable managers.

• Returns-based style analysis is a top-down approach that involves estimating the risk exposures from an actual return series for a given period. Although RBSA adds an additional analytical step, the analysis is straightforward and should identify the important drivers of return and risk factors for the period analyzed. It can be estimated even for complicated strategies and is comparable across managers and through time. The disadvantage is that RBSA is an imprecise tool, attributing performance to an unchanging average portfolio during the period that might not reflect the current or future portfolio exposures.

• Holdings-based style analysis is a bottom-up approach that estimates the risk exposures from the actual securities held in the portfolio at a point in time. HBSA allows for the estimation of current risk factors and should identify all important drivers of return and risk factors, be comparable across managers and through time, and provide an accurate view of the manager’s risk exposures. The disadvantages are the additional computational effort, dependence on the degree of transparency provided by the manager, and the possibility that accuracy may be compromised by stale pricing and window dressing.

• The prospectus, private placement memorandum, and/or limited partnership agreement are, in essence, the contract between the investor and the manager, outlining each party’s rights and responsibilities. The provisions are liquidity terms and fees. Limited liquidity reduce the investor’s flexibility to adjust portfolio allocations in light of changing market conditions or investor circumstances. On the other hand, limited liquidity allows the funds to take long-term views and hold less liquid securities with reduced risk of having to divest assets at inopportune times in response to redemption requests. A management fee lowers the level of realized return without affecting the standard deviation, whereas a performance fee has the added effect of lowering the realized standard deviation. The preference is for more-linear compensation to reduce the incentives to change the portfolio’s risk profile at inflection points.

• The choice between individual separate accounts and pooled (or commingled) vehicles is dependent upon the consistency with the investment process, the suitability for the investor IPS, and whether the benefits outweigh the additional costs.

• Investment management fees take one of two forms: a fixed percentage fee based on assets under management or a performance-based fee which charges a percentage of the portfolio’s total return or excess return over a benchmark or hurdle rate. Performance-based fees work to align the interests of managers and investors because both parties share in investment results. Most managers that charge a performance fee also charge some level of fixed percentage fee to aid business continuity efforts. Fee structures must be designed carefully to avoid favoring one party over the other.