The Ten Commandments of Manager Selection
Large investment consultants tend to talk about fund manager selection as if it were a science; something that can be boiled down to a process that, if just pursued with enough diligence and rigor, will lead to predictable alpha. Unfortunately, that’s just not true. Manager selection is at least as much art as science.
The need for ‘art’ in any process makes it hard to fully articulate a formula for success. However, it’s relatively easy to articulate rules of thumb for avoiding the worst mistakes. Below is a list of 10 hard-earned lessons and personal ‘best practices’ for conducting manager research, gathered over the years from within our network.
1. Focus your resources: Conduct manager research only in markets or niches where there is enough inefficiency to reward active management. In other areas, go for the lowest-cost option that provides a representative exposure. ‘Inefficiency’ can stem from opacity, illiquidity, lack of active players, non-standardization of investable instruments, recent market dislocation, or a structural imbalance between supply and demand for capital.
2. Find the ‘edge’: Articulate and find evidence of one or more observable sources of competitive advantage for the manager in question. There are many forms of edge: informational, analytical, operational, scale/size/speed, reputational, relationship-based, and more…
3. Look for convergence of form and function: For example, a venture capital fund manager should be entrepreneurial, risk-forward, open-minded, imaginative, savvy and well networked. A government bond fund manager should perhaps be the opposite: cerebral, risk-averse, big-picture oriented, and ideally cloistered away with a Bloomberg and his or her quant models.
4. Condition ‘style preference’ on the big picture: Even an Olympic swimmer will not make much headway against a strong and persistent tide. Consider which way the tide is flowing for the managers you’re researching. Managers with a penchant for speculative growth or deep value may not be the right choice at the end of a market cycle, but they might be just the ticket in the early innings of a recovery, when sentiment and expectations have bottomed.
5. Differentiate returns: Clearly differentiate between performance resulting from structural aspects of the strategy, and performance resulting from the active decisions that influence time-varying portfolio exposures. This can only be done with careful quantitative analysis and judgement, but without it, there is zero possibility of differentiating between lucky and skillful managers.
6. Don’t ignore the higher moments: Pushing risk out of places it is visible (volatility) and into places where it is harder to observe (e.g., skew or latent risk) is very, very common, especially in alternatives.
7. Be open minded: Newer, less mainstream asset classes or strategies may be largely de-coupled from mainstream securities markets and can offer de-correlated risk premia that can be extremely additive to a multi-asset portfolio’s risk adjusted performance.
8. Beware the trifecta of operational risk: Performance fees, capacity issues and liquidity mismatches can swamp even high-alpha opportunities. Performance fees are usually one-sided, can dramatically alter the payoff structure to clients/investors, and are predictive of excess risk-taking. Be aware of the (often inevitable) dilution of alpha or value-add over time as successful managers gather excess assets. Preference managers who commit to reasonable AUM caps. Be aware of the multitude of ways these caps can be gamed. Finally, acknowledge that any liquidity mismatch between underlying assets and the fund’s liquidity terms is a significant hazard.
9. Plan exits: Articulate (at the outset) what conditions or changes of circumstances would lead to exiting the strategy, asset or fund. This is an effective antidote to the hazards of ‘falling in love’ with a position, or simply shifting the goal posts.
10. Know when to walk away: When fund managers side-step questions, it’s a strong indicator that you’ve hit on something important. Keep digging. If the manager is unwilling to share data, or address all questions in detail, for any reason, just… walk… away… no matter how much time or effort you’ve already committed to the research.
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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.