Learning Module 2: Investment Manager Selection
1. Manager Selection Framework
LOS: Describe the components of a manager selection
process, including due diligence.
The process aims to find a manager with a repeatable
process that generates the expected return distribution.
Components
- Universe Definition: Reduce the full set of
managers to a manageable feasible set (screening).
- Methods: Third-party categorization, RBSA, HBSA,
experience.
- Quantitative Analysis: Analyzing performance track
record (attribution, appraisal, capture ratios).
- Qualitative Analysis (Due Diligence):
- Investment Due Diligence: Philosophy, Process,
People, Portfolio (The “4 Ps”). Focuses on the “alpha” generation.
- Operational Due Diligence: Firm stability,
infrastructure, compliance, back office, terms. Focuses on business
risks (not investment risks).
2. Type I and Type II Errors
LOS: Contrast Type I and Type II errors in manager
hiring and continuation decisions.
- Null Hypothesis (\(H_0\)): The manager has no
skill.
| Type I |
Rejecting \(H_0\) when
it is true. |
Hiring/Retaining a bad manager. |
High Regret. Explicit cost (fees,
losses). Transparent failure. |
| Type II |
Failing to reject \(H_0\) when it is false. |
Not hiring/Firing a good manager. |
Low Regret. Opportunity cost. Less
transparent (harder to measure). |
- Behavioral Bias: Decision makers focus more on
avoiding Type I errors (hiring a “dud”) because they are visible and
painful.
- Costs: Dependent on the distribution of skilled
vs. unskilled managers. If markets are efficient (distributions overlap
heavily), the cost of errors is lower.
- Mean Reversion: If performance is mean-reverting,
firing a poor performer (who then bounces back) is a Type I error
(hiring/retaining decision frame) or Type II (firing decision frame).
Note: The text frames firing a skilled manager as Type II.
3. Style Analysis
LOS: Describe uses of returns-based and
holdings-based style analysis.
Returns-Based Style Analysis (RBSA)
- Method: Top-down. Regresses portfolio returns
against a set of style indices (factors).
- Pros: Easy, creates a “custom benchmark,” requires
only return data, objective.
- Cons: “Average” exposure over the period (static),
backward-looking, slow to detect drift, inaccurate for illiquid assets
(stale pricing).
Holdings-Based Style Analysis (HBSA)
- Method: Bottom-up. Analyzes actual securities held
at a point in time.
- Pros: Current snapshot, precise risk factor
estimation.
- Cons: Data intensive, subject to window
dressing (manager cleaning up portfolio before reporting),
dependent on transparency/data delay.
Active Share vs. Tracking Risk
- Active Share: Measures how different portfolio
holdings are from the benchmark (0 = Index Fund, 1 = No overlap).
- \[Active Share = \frac{1}{2} \sum
|w_{port} - w_{bench}|\]
- Tracking Risk: Volatility of excess returns.
| Low Tracking Risk |
Closet Indexer |
Diversified Stock Picker |
| High Tracking Risk |
Factor Bets / Sector Rotation |
Concentrated Stock Picker |
4. Capture Ratios and Drawdowns
LOS: Describe uses of upside/downside capture,
drawdowns, and evaluating managers.
Capture Ratios
- Upside Capture (UC): Manager Return / Benchmark
Return (when Bench > 0). Target > 100%.
- Downside Capture (DC): Manager Return / Benchmark
Return (when Bench < 0). Target < 100%.
- Capture Ratio (CR): \(UC
/ DC\).
- CR > 1: Positive asymmetry
(Convex return profile). Desirable.
- CR < 1: Negative asymmetry
(Concave return profile). Undesirable.
- Interpretation: Positive asymmetry means the manager
captures more of the upside than the downside.
Drawdown
- Maximum Drawdown: Largest peak-to-trough
decline.
- Drawdown Duration: Time from start of loss to full
recovery (made of “Drawdown phase” + “Recovery phase”).
- Significance: Large drawdowns require geometrically larger
gains to recover (e.g., 50% loss needs 100% gain). Drawdowns are “stress
tests” for the investment process and operational stability.
5. Investment Philosophy & Process
LOS: Evaluate a manager’s investment philosophy and
decision-making process.
Philosophy
The foundation. Must be Clear,
Consistent, and based on reasonable assumptions about
market inefficiencies. * Inefficiencies: *
Behavioral: Temporary mispricings caused by investor bias
(e.g., panic selling). * Structural: Caused by
rules/regulations (e.g., forced selling by pensions). * Key
Questions: Is the “edge” (informational, analytical, or
behavioral) sustainable? Is there capacity?
Decision-Making Process
- Signal Creation (Idea Generation): Unique, timely,
or interpreted differently.
- Signal Capture (Implementation): Translating idea
into a trade.
- Portfolio Construction: Sizing, stop-losses, risk
limits.
- Monitoring: Feedback loop.
6. Behavioral Factors in Teams
LOS: Discuss how behavioral factors affect
investment teams and mitigation techniques.
Teams are common (mitigate key person risk), but introduce group
biases: 1. Groupthink: Desire for harmony overrides
dissent. * Mitigation: Diversity, secret ballots, devil’s
advocate role. 2. Authority Bias: Deferring to the
leader/most senior person. * Mitigation: Senior members speak
last. 3. Aversion to Complexity: Spending
disproportionate time on trivial, easy-to-understand issues
(“Bike-shedding”). * Mitigation: Strict agendas, tackle hard
topics first. 4. Confirmation Bias: Seeking info that
supports the thesis.
7. Investment Vehicles
LOS: Evaluate costs and benefits of pooled vehicles
vs. separate accounts.
Separately Managed Accounts (SMA)
- Pros:
- Control/Customization: Client sets constraints
(ESG, taxes).
- Tax Efficiency: Tax-loss harvesting specific to
client.
- Transparency: Real-time visibility.
- Ownership: Client owns the actual securities
(safety in bankruptcy).
- Cons: Higher costs, higher minimums, harder to
scale for manager.
Pooled Vehicles (Mutual Funds, ETFs, Hedge Funds)
- Pros: Lower costs (economies of scale), lower
minimums, simpler operational burden.
- Cons: “One size fits all,” embedded capital gains
(mutual funds), liquidity gates (hedge funds).
8. Contracts and Liquidity
LOS: Compare manager contracts, provisions,
pros/cons.
Liquidity Terms
- Lockup:
- Hard Lock: No withdrawals allowed for a period.
- Soft Lock: Withdrawals allowed but with a penalty fee.
- Gates: Limit on the % of fund assets that can be
redeemed at one time.
- Notice Period: Time required to notify fund before
redemption.
- Side Pockets: Segregated illiquid assets (cannot be
redeemed until liquidated).
Private Equity Liquidity
- Capital Calls: Obligation to fund investments when
requested.
- Term: Fixed life (e.g., 10 years).
- Distributions: Capital returned only upon exit
(harvesting).