Practical analysis for investment professionals
11 February 2016

Current Thinking in Investment Manager Selection

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 ManagersNew 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 ManagementNew 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 GenderIn 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

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, is director of journal publications at CFA Institute, where he supports a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

5 thoughts on “Current Thinking in Investment Manager Selection”

  1. Brad Case, PhD, CFA, CAIA says:

    Mark,
    Your article seems to proceed from an initial assumption that manager selection is worth the time and cost required. It’s easy to see how poor manager selection can hurt returns, but you seem simply to assume that good manager selection can predictably result in returns greater than a low-cost passive allocation to the same or similar assets.
    I have not seen any solid empirical evidence that manager selection is worthwhile. Can you point to any?
    –Brad

  2. Mark Harrison, CFA, ASIP says:

    Hi Brad,

    many thanks for your query which is a very pertinent one.

    The academic debate around the existence of active management alpha is extensive and fascinating but was not the focus of this curation. A literature review and discussion of the mixed evidence for active manager alpha can be found in Scott Stewart’s CFA Institute Research Foundation monograph, Manager Selection, Chapter 2, which is referenced in the article. You may also find more recent papers on the topic abstracted in CFA Digest or published in the FAJ on the http://www.cfapubs website.

    Hope that helps!

    Best regards,

    Mark

    1. Brad Case, PhD, CFA, CAIA says:

      Thanks, Mark. As you note, the debate on whether active manager alpha exists is still raging–but that’s not actually the question I was asking. The existence of active manager alpha is a necessary but not sufficient condition for expenditures on manager search to be worthwhile: that is, if active managers can produce alpha, then it still has to be shown that manager selection can identify, ex ante and after internal as well as external fees and expenses, those managers who will produce alpha in the future.
      The main research I have seen on this question is the paper “Picking Winners? Investment Consultants’ Recommendations of Fund Managers” by Jenkinson, Jones & Martinez (http://onlinelibrary.wiley.com/doi/10.1111/jofi.12289/full), which is slated for publication later this year in Journal of Finance. The authors conclude “we find no evidence that these recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless.”
      That’s pretty damning for the entire manager selection exercise, regardless of whether active management alpha exists.

  3. Hi Brad,

    Stewart’s monograph also surveys research on the alpha persistence of the manager-selection tier in Chapter 7. As with active management alpha Stewart describes a mixed picture. I haven’t yet seen the Jenkinson, Jones & Martinez paper but it is usually appropriate to be cautious and reserve judgement about each new study and any limitations of its data, methodology and conclusions.

    Can you think of any practical reasons why, despite unfavourable evidence, there are still thousands of highly qualified, experienced and rational actors employed in this tier of activity rather than investing 100% passively? Is there something wrong with the makeup of the indices perhaps?

    Best regards,

    Mark

  4. Brad Case, PhD, CFA, CAIA says:

    Thanks, Mark–that’s very helpful. I believe I have printed out Scott Stewart’s monograph before, but I don’t remember having read it carefully and I look forward to doing so now. My initial scan suggests that my concerns regarding the efficacy of the manager search function are well placed: for example, on page 93 Stewart summarizes one study in which the authors “confirmed that on average, institutional investors’ changes in manager allocation led to underperformance in all asset classes. In fact, the authors estimated that the economic impact of manager selection changes, before transaction costs, was more than $170 billion.”
    To answer your question as to why investors would bother with active investment management–and therefore manager searches–despite unfavourable evidence, I have in mind two main explanations. The first is lack of information: for example, in real estate (the asset class in which I am most knowledgeable) actively managed private equity real estate investment managers have underperformed passively managed exchange-traded equity real estate, on average, over the 38-year available historical time period (and every reasonable sub-period) even after controlling for differences such as leverage, property type mix, and location–in fact, I have literally never seen any piece of empirical evidence suggesting that private equity real estate investing has outperformed passive exchange-traded real estate. Yet most institutional investors seem genuinely surprised, and even skeptical, to hear about those empirical findings. (The same goes for actively managed hedge funds and private equity funds, although there is some empirical counter-evidence.)
    The second explanation is agency problems: the possibility that members of the institutional investment community–plan sponsors, investment consultants, active investment managers, etc.–may prefer active management and manager searches not because they result in investment performance that is better for the beneficiaries (retirees or workers covered by pension plans, students supported by endowments, etc.) but rather because active management and manager searches are better for those members of the institutional investment community themselves.
    I would be interested in your opinions, too.
    –Brad

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