Current Thinking in Investment Manager Selection

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 circumstances) 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 circumstances, 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.

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