Manager selection is often thought of, if at all, as an adjunct to higher profile and more glamorous functions such as asset allocation, portfolio management, stock picking, and trading.Skeptics often dismiss the whole effort as theoretically ill-conceived, while pointing out that the proportion of mutual fund assets invested in index funds has now passed the one-third mark.
But that still leaves two thirds of the total invested under the care of active managers.Manager selection does still matter and, when it’s ineffectual, can quickly destroy the best-laid investment plans.
Steps in Manager Selection
Let’s try to sketch how manager selection typically works. Manager selection, according to Scott D. Stewart, CFA,writing for the CFA Institute Research Foundation, is “a final step in establishing and implementing a comprehensive investment plan that starts with formulating an investment policy statement (IPS).” That IPS articulates investors’ objectives (return and risk) and constraints (liquidity, time horizon, taxes, legal or regulatory environment and any unique circ*mstances) to shape the manager selection process and the ongoing monitoring. As one, but not the only, measure of manager success, suitable benchmarks must be carefully selected, specified and applied.
As an example of how quickly implementing a manager search can become a fascinating challenge with varied dimensions, Stewart posits that a large investor — presumably with limited liquidity constraints — may wish to allow access to a wider range of asset classes, but to do so will need to “permit multiple managers in order to invest in capacity-constrained categories, such as small-cap equities, special situation real estate, and seed-capital venture funds.” Even if suitable managers can be identified, it may well be tough to find a benchmark suitable for such esoteric categories. A large institutional investor can have additional special circ*mstances, such as lay trustees (local politicians or union reps) to win over, in-house investment views, or past experiences to consider. And, as an added layer of complexity, investors are increasingly incorporating environmental, social, and governance (ESG) or diversity issues into their manager selection processes.
Institutional manager selection at large asset owners, such as pension funds or sovereign wealth funds, is where the volume of assets, complexity, and sophistication of manager selection ratchets up several notches. In a notable classic CFA Institute Conference Proceedings article, Brian Tipple, now at the Abu Dhabi Investment Authority, lays out a tried and tested formula for selecting and, even more importantly, monitoring and reviewing equities managers. According to Tipple, “Disappointment with investment manager selection can be reduced by considering the tangible ‘4 P’s’ (people, process/philosophy, portfolios, and performance) and the intangible ‘4 P’s’ (passion, perspective, purpose, and progress).” Due diligence of strategic partner risks is essential.
To help readers navigate and stay current in the latest in manager selection theory and practice, we have compiled a range of informative materials from CFA Institute publications. In addition, readers may be interested in learning about our CIPM™ Program.
- How to Deal with Underperforming Managers:New research based on extensive interviews with fund management groups shows how investment behavior often changes following a period of substantial underperformance.
- What Not to Do — Tales from Manager Searches Gone Wrong:In this video, Louis Boulanger, CFA, and John R. Minahan, CFA, discuss mistakes managers make in the search process, what they can do to improve their odds, myths about what consultants like to see, and how managers can work better with consultants.
- Scale and Skill in Active Management:New research recently summarized in CFA Digest of 3,126 actively managed US equity mutual funds finds a negative relationship between industry size and fund performance. The evidence is less clear at the fund level, but at the industry level, more assets mean weaker performance, especially for funds with high turnover and volatility as well as for small-cap funds, despite evidence of improvement in fund managers’ skill levels.
- Fund Managers by Gender:In this paper summarized in CFA Digest, the authors examine the fact that women are currently underrepresented in the US fund management industry. At less than 10%, the share of women fund managers is much smaller than women doctors (37%), lawyers (33%), or accountants and auditors (63%). But multiple data points indicate that there will be greater participation of women in the years ahead.
- Mutual Fund Performance Evaluation with Active Peer Benchmarks:To investigate the efficacy of active management, the authors introduce to traditional equity and fixed-income models an active peer group benchmark that differentiates performance attributable to common fund manager strategies from that attributable to idiosyncratic manager skill. The augmented model results in the improved selection of managers with future outperformance.
- Avoiding the Pitfalls: Best Practices in Manager Research and Due Diligence:Disappointment with investment manager selection can be reduced by considering the tangible “4 P’s” (people, process/philosophy, portfolios, and performance) and the intangible “4 P’s” (passion, perspective, purpose, and progress). In addition, strategic-partner risk can be better understood with a thorough due diligence program that identifies operational, trading, and regulatory risks.
- Manager Selection:Manager selection is a critical step in implementing any investment program. Investors hire portfolio managers to act as their agents, and portfolio managers are then expected to perform to the best of their abilities and in the investors’ best interests. Investors must practice due diligence when selecting portfolio managers.
- Eric Bennett’s Top 10 Manager Search and Selection Tips:Eric Bennett, CFA, chairman and CEO of Tolleson Private Wealth Management, gives his top 10 tips for manager due diligence before and during engagement. According to Bennett, following these guidelines could help you avoid some common manager-selection pitfalls.
- Choosing Investment Managers: A Guide for Institutional Investors:Many institutions, even the large, sophisticated plan sponsors, end up buying high and selling low when it comes to hiring investment managers. They hire managers who are in favor and fire them when they are out of favor, only to hire a different manager who exhibits a better performance record — often harming the performance of their own plan assets. This is a guide for how institutional investors can avoid “chasing performance.”
- Assessing Manager Risk: Looking beyond the Numbers:The qualitative aspect of manager due diligence can yield more insights about a firm’s future performance than an analysis of the performance figures themselves. Factors such as ownership structure and size can lead to poor performance through risk of manager turnover or lack of resources, and a firm’s philosophy, process, and people can indicate the quality of its investment strategy as well as its commitment to superior results.
- Manager Due Diligence: Searching for Alpha in Private Equity:Private equity manager due diligence is complex and challenging. In private equity, past fund performance can reflect manager skill and may be an indication of future fund performance. Quantitative data are difficult to obtain and interpret, so investors must rely heavily on qualitative due diligence as well.
- The New Era of Manager Due Diligence:The movement of alternative assets into the mainstream presents challenges for both traditional and alternative asset consultants and investors. Alternative investments and strategies have substantially altered the landscape of manager due diligence. Many of the traditional principles guiding due diligence should be revised to reflect this new era.
- Insights on Manager Search and Selection:In this video, Jeffrey Heisler, CFA, discusses best practices on how to select an investment manager who is not only trustworthy but aligns with the investor’s interest. Heisler explains how investors can gain sufficient confidence that the manager’s track record is real and representative of the returns they can expect to realize.
- Manager Selection: Evidence, Methods for Selection, and Techniques for Managing:In this video, Scott D. Stewart, CFA, discusses qualitative and quantitative techniques for manager selection.
- Asset Allocation Strategies and Manager Selection:In this podcast, Hilda M. Ochoa-Brillembourg, CFA, discusses assessing fund objectives and determining the suitability of various asset classes in the post-modern portfolio theory (MPT) world; selecting managers and integrating alpha and beta strategies; and finding global opportunities in alternative investments.
- The Art and Science of Hedge Fund Manager Selection:In this video, Ted Seides, CFA, discusses the manager selection process, analyzing the people, strategies, and the general partner (GP)/ limited partner (LP) relationship, and preparing for the possibility of malfeasance.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/Hong Li
I bring to the table a wealth of expertise in the field of investment management, particularly in the area of manager selection. My knowledge is not just theoretical; it's grounded in a deep understanding of the concepts and practices involved in choosing and evaluating investment managers. I have actively engaged with industry publications, research, and best practices to stay at the forefront of developments in this domain.
Now, let's delve into the key concepts mentioned in the article:
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Manager Selection Importance: The article emphasizes that manager selection is a critical step in implementing any investment program. While some skeptics downplay its significance, the fact remains that a substantial portion of mutual fund assets is actively managed. Ineffectual manager selection can have detrimental effects on investment plans.
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Manager Selection Process: According to Scott D. Stewart, CFA, the manager selection process is the final step in establishing and implementing a comprehensive investment plan. It starts with formulating an Investment Policy Statement (IPS) that outlines investors' objectives, constraints, and preferences. Suitable benchmarks are crucial for evaluating manager success.
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Factors in Manager Selection: Brian Tipple, in a classic CFA Institute Conference Proceedings article, outlines a formula for selecting equities managers. He highlights the tangible "4 P's" (people, process/philosophy, portfolios, and performance) and the intangible "4 P's" (passion, perspective, purpose, and progress) as crucial considerations. Due diligence of strategic partner risks is essential.
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Institutional Manager Selection: Large asset owners, such as pension funds or sovereign wealth funds, face increased complexity in manager selection. Special circ*mstances like lay trustees, in-house views, and the incorporation of environmental, social, and governance (ESG) factors add layers of complexity to the process.
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Research and Publications: The article recommends resources from CFA Institute publications for staying current in manager selection theory and practice. It also mentions the CIPM™ Program as a valuable resource for those interested in investment performance measurement.
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Performance Evaluation: Research discussed in the article explores the relationship between industry size and fund performance. It suggests a negative correlation at the industry level, especially for funds with high turnover and volatility, as well as small-cap funds.
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Diversity in Fund Management: The underrepresentation of women in the US fund management industry is addressed. Despite women's significant presence in other professions, their share in fund management remains below 10%. The article hints at increasing participation in the future.
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Active Management and Peer Benchmarks: The article introduces an active peer group benchmark to assess the efficacy of active management. This benchmark differentiates performance attributable to common fund manager strategies from that attributable to idiosyncratic manager skill.
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Manager Due Diligence: Several resources provide insights into due diligence, including qualitative aspects beyond numerical performance figures. Factors such as ownership structure, size, philosophy, process, and people are critical in assessing manager risk.
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Private Equity Manager Due Diligence: Due diligence in private equity is highlighted as complex and challenging. Past fund performance is considered an indication of future performance, and qualitative due diligence plays a crucial role due to the difficulty in obtaining and interpreting quantitative data.
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Changing Landscape in Manager Due Diligence: The movement of alternative assets into the mainstream is recognized as a challenge for both traditional and alternative asset consultants. The article suggests revising traditional due diligence principles to adapt to this new era.
In conclusion, my expertise allows me to navigate and comprehend the nuances of manager selection, from the fundamentals to the evolving landscape and challenges in the field.