Whether you are a trustee, a foundation administrator, a plan sponsor, an investment consultant or an investment committee member of an endowment or a fund of financial assets, you have likely been involved in the task of screening, recruiting and evaluating investment managers. Selecting an investment manager is a process in itself. In this article I would like to give a high-level overview of current best practices from a theoretical and a practical perspective.
What empirical studies show us so far are the following key outcomes: (a) asset allocation is the main driver of returns; (b) historic returns offer very limited predictive power of future performance; (c) fire and hire decisions are costly and have generally led to inferior investment results; and (d) active management can generate outperformance, however it is difficult to earn positive alpha net of fees. Indexing and passive management, an alternative to active management, also incurs costs and requires diligence to be implemented effectively.
Traditionally, selecting investment managers involved running a due diligence questionnaire on what are known as the ‘four Ps’: people, philosophy, process and performance.
‘People’ refers to questions related to the staff involved in the investment management process, such as what experience and qualifications the team members have, how long the team has been working at the firm, and who is responsible for the final investment decision making.
‘Philosophy’ refers to the firm’s fundamental beliefs in achieving the targeted investment results. What is the firm’s investment style? Does it focus on stock-picking or on timing trends in the macro economy? And does the investment manager conduct screening of investment ideas through in-house research?
‘Process’ is about the execution of the investment philosophy. How are investment ideas analysed and how does the investment manager decide when and what to buy or sell? What controls are in place to ensure that the investment manager remains in line with the risk parameters? What are the reporting capabilities of the investment manager? How disciplined is the team in applying this process and how does it adjust to varying market environments?
Investors should define measures of success and apply suitable benchmarks to evaluate managers’ performance
The last element is ‘Performance’. Although it may seem like the easiest element to assess due to its quantitative nature, it often leads to poor performance-chasing decisions. Secondly, a higher absolute return figure, say a return of five per cent versus three per cent, may not necessarily be superior if the risk or volatility of the investment is significantly higher.
Performance has to be analysed in the context of the investment style and the risks associated with the manager’s investment universe. Moreover, understanding performance is about assessing how consistently the investment process has been implemented and how successful the investment decisions have been.
Although the information collection process has become a relatively standardised exercise, it is still a widely used approach to produce an initial assessment and uncover areas that need to be explored further. Manager selection is not only about compiling a ‘checklist’, but it should be more about investigating and improving your depth of knowledge on the value that candidate investment managers can deliver.
So how can the manager selection process be improved given the information gathered on investment managers and the large body of academic research?
Manager selection should be the last phase of a comprehensive investment plan that is outlined in an Investment Policy Statement (IPS). More effort should be dedicated to defining the investment objectives and risk constraints and establishing an asset allocation. The manager selection process as well as the skills and capabilities required should also be laid out in the IPS.
Investors should define measures of success and apply suitable benchmarks to evaluate managers’ performance. When assessing the track record of investment managers, investors should rely more on return patterns and the investment style, as opposed to comparing absolute returns, and not be overly focused on short-term results, unless the latter results are extreme.
Underperformance is not a sufficient reason to fire an investment manager. More information should be requested prior to terminating a relationship. Research shows that fired managers have in general outperformed newly hired managers in the subsequent one-year and five-year periods. And this does not take into consideration the costs related to switching managers.
Regular reviews should not only serve to evaluate performance but also to deepen the level of knowledge about the selected investment managers. Probably the most effective way of sifting out lucky from skilful managers is to keep tabs on discrete investment decisions and the basis or intentions underlying these decisions.
Lastly, it is important that even the selection process is reviewed on a regular basis. There is no magic formula to identify the next top-performing managers in advance. However, investors can improve their results through a disciplined approach and the continuous development of the knowledge base and the required skill set for successful selection.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Matthias Busuttil is senior portfolio and investment manager at Curmi and Partners Ltd.
www.curmiandpartners.com