Investment Management Overview

Asset Manager Selection

Objectives

• To find the best possible asset manager for a specific mandate or asset class.
• Most investors rely on managers to select securities as they don't do it themselves.
• Selecting external asset managers can provide an advantage in Security Selection and Trade Execution.

Considerations in Selection

• Investors often select managers based on low cost and good track record, but past performance is not a reliable indicator of future results.
• Recognize that cheap active managers are costly if they don't consistently provide net excess returns.
• Empirical evidence suggests that some managers can consistently produce Alpha, but average performance is often below benchmarks.

Key Qualities of Successful Managers

• Intelligence: Assessed via IQ tests and other standardized evaluations.
• Knowledge: Includes advanced degrees and work experience.
• Focus: Difficult to measure but can be estimated by work hours.
• Long-term and independent thinking are critical.
• Alignment of interests through compensation.

Active vs. Passive Management

Definitions

• Passive Strategies: Assume markets are efficient; aim to capture market risk (systematic risk or Beta).
• Active Strategies: Assume markets are inefficient; seek to exploit security mispricings (Alpha return).
• Factor Investing: A third option that has grown, particularly Smart Beta with ETFs.

Considerations

• Decision depends on specific investment mandates and asset classes.
• Cost and outperformance expectations are key drivers.
• Active management is justifiable only with positive excess risk-adjusted return.
• Alternative assets often managed actively due to lack of benchmarks and pricing transparency.

In-house vs. Outsourced Asset Management

Pros and Cons

• Outsourcing introduces third-party involvement, which could lead to differing standards and loss of control.
• Insourcing allows better quality control and alignment with company culture but requires investing in technical support and infrastructure.
• Institutional investors may benefit from combining both approaches.

Factors to Consider

• Cost efficiency, research access, and technology.
• Complexity of the investment mandate relative to liabilities.
• Operational, regulatory risks, and investment compliance.

Manager Life Cycle Process

Steps

1. Selection:

   • Request For Information (RFI) and Request For Proposal (RFP) to shortlist candidates.
   • Due diligence via on-site visits to verify information and capabilities.
   • Negotiate contractual terms post-selection.

2. Monitoring

   • Ensure compliance with investment policy/guidelines.

3. Evaluation

   • Evaluate based on market benchmark, peer group, and inflation plus a margin.
   • Performance evaluation encompasses returns, services, operations, and fees.

4. Corrective Actions

   • Underperforming managers placed on a watchlist and may be deselected after monitoring.

Asset Manager Due Diligence

Quantitative Factors

• Performance appraisal and style analysis to understand risk exposures and return drivers.
• Consistency with the manager's philosophy and investment process.

Qualitative Factors

• Investment philosophy clarity.
• Team expertise and experience.
• Portfolio construction effectiveness.
• Operational integrity and infrastructure.

Fiduciary Duty and Incentives

Fiduciary Duty

• Investment fiduciaries have a legal responsibility to manage others' money, prioritizing client interests.
• Emphasizes prudence in return creation rather than just performance.

Incentives and Principal-Agent Problem

• Compensation structures include management and performance fees, aligning interests with investors.
• Performance fees encourage risk-taking but also higher alphas.
• Incentive misalignment can lead to actions counter to investor interests.

Recommendations

• Avoid becoming a captive client; manage transitions carefully.
• Spend time understanding managers' alpha generation, portfolio construction, and strategy.
• Combine internal and external asset management for motivation and optimization.
• Acknowledge limitations and seek expert advice when needed.

References

• Manager Selection, Scott D. Stewart, CFA.
• The Principal-Agent Problem in Finance, Sunit N. Shah.
• Various sources and CFA Institute publications.

Annexes

Fee Structures

• Comparison of standard fees vs. performance-based fees.
• Fee structures can be symmetrical or bonus-based affecting manager behavior.

Industry Trends

• Growth in passive management, factor investing, and mega-trend investing.
• Increasing role of big data and robo-advisers.

Asset Management Industry

• Distinctions between large asset managers and boutique firms.
• Ownership structures influence on key personnel retention and management alignment.