Welcome to Investment Manager Selection!
Selecting an investment manager is a bit like choosing a pilot for a long-haul flight. You aren't just looking for someone who has landed safely before; you want someone with a rigorous process, a skilled crew, and the right equipment to handle any turbulence. In this chapter, we move beyond just looking at a "scorecard" of past returns and dive into how to choose a manager who can actually deliver future results.
1. The Framework for Manager Selection
Before we start picking names, we need to understand the costs and risks involved. Selecting a manager isn't free—it takes time and money. More importantly, we have to worry about making mistakes. In the CFA world, we focus on two specific types of errors.
Type I and Type II Errors
Think of these as "hiring regrets":
Type I Error (The "False Positive"): This occurs when you hire or keep a manager who actually has no skill. You thought they were good because they had a "hot hand," but it was really just luck.
Result: You pay high fees for poor performance.
Type II Error (The "False Negative"): This occurs when you fire or fail to hire a manager who actually does have skill. Maybe they had a bad year due to temporary market conditions, and you let them go right before they started winning again.
Result: You miss out on the Alpha (excess returns) they would have generated.
Quick Review:
- Type I: Keeping a "Zero."
- Type II: Firing a "Hero."
Students often find these tricky. Just remember: Type I is about commission (doing the wrong thing), and Type II is about omission (missing out on the right thing).
Key Takeaway
Successful manager selection aims to balance these risks. We use due diligence to minimize Type I errors and patience to avoid Type II errors.
2. The Components of Manager Selection: Philosophy, Process, and People
To understand if a manager's past success was luck or skill, we look at what we call the "Three Ps". Don't worry if this seems like a lot of detail; it’s basically just doing a deep background check on how they work.
Investment Philosophy (The "Why")
This is the manager's core belief system. Do they believe markets are inefficient in the small-cap space? Do they believe value stocks eventually revert to the mean?
Important: A good philosophy should be consistent and coherent. If a manager suddenly changes their philosophy, that’s a red flag!
Investment Process (The "How")
This is the step-by-step "factory line" for picking stocks or bonds. A robust process usually involves:
1. Idea Generation: Where do they find new investments?
2. Analysis: How do they research them?
3. Portfolio Construction: How do they decide how much of each asset to buy?
4. Risk Management: What is their plan if things go wrong?
Investment People (The "Who")
Who is actually making the decisions? We look at:
- Experience and Stability: Has the team worked together for a long time?
- Succession Planning: What happens if the star manager retires?
- Alignment of Interests: Do the managers invest their own money in the fund? (This is often called "eating your own cooking.")
Key Takeaway
If you understand the Philosophy, the Process, and the People, you can judge if a period of underperformance is just "bad luck" or if the manager has actually lost their "edge."
3. Operational Due Diligence (The "Hidden" Risks)
Even a manager with a great track record can fail if their business is poorly run. This is where Operational Due Diligence (ODD) comes in. We aren't looking at the stocks they buy; we are looking at the "plumbing" of the firm.
Things to check:
- Compliance: Are they following the laws and regulations?
- Trade Execution: Are they getting the best prices when they buy and sell?
- Valuation: Who decides what the assets are worth? (Ideally, an independent third party).
- Information Technology: Are their systems secure from hackers?
Did you know? Many of the biggest hedge fund blowups in history weren't caused by bad stock picking, but by operational failures or fraud! ODD is your shield against these disasters.
4. Performance Fees and Incentives
How we pay a manager dictates how they behave. There are two main structures:
1. Assets Under Management (AUM) Fees
A simple percentage (e.g., 1%).
Pro: Very stable and easy to calculate.
Con: It doesn't necessarily reward good performance; it rewards the manager for just getting more clients.
2. Performance-Based Fees
These are designed to align the manager's interests with the investor's.
Formula: \( \text{Total Fee} = \text{Base Fee} + \text{Sharing Amount} \times (\text{Return} - \text{Benchmark}) \)
Note: We usually use a "High-Water Mark" to ensure we don't pay for the same performance twice!
Types of Performance Fees:
- Symmetrical: The manager gets a bonus for doing well, but their fee is reduced if they do poorly. (Investors love this!)
- Asymmetrical (Bonus): The manager gets a bonus for doing well, but if they do poorly, they still get their base fee. This can encourage the manager to take too much risk because they have "upside" but limited "downside" (like a call option).
Key Takeaway
Always check if a fee structure encourages the manager to take risks that you aren't comfortable with.
5. Monitoring and When to Fire a Manager
Manager selection isn't "set it and forget it." You must monitor them continuously. However, you must be careful not to fire them just because they had one bad quarter (avoiding that Type II Error).
Watch out for:
- Style Drift: A "Value" manager starts buying expensive "Growth" stocks because they are trendy.
- Personnel Turnover: The lead researcher or PM leaves.
- Significant AUM Growth: Sometimes a fund gets too big to execute its strategy effectively (diseconomies of scale).
Common Mistake: Don't fire a manager simply because they underperformed their benchmark if their process is still sound. Markets go through cycles, and no strategy works all the time!
Final Summary Quick-Check
1. Type I Error: Hiring/keeping a bad manager.
2. Type II Error: Firing/missing a good manager.
3. The 3 Ps: Philosophy, Process, People.
4. ODD: Checking the business "plumbing" to prevent fraud or failure.
5. Symmetrical Fees: Reward for gain, penalty for loss.
6. Asymmetrical Fees: Reward for gain, no penalty for loss (can lead to excessive risk).
Keep going! You're mastering the art of building a "dream team" of investment managers. Just remember: look past the glossy returns and focus on the repeatable process!