Title: Investment Management Overview
URL Source: blob://pdf/4a8f0549-6eef-4abf-a30b-3889157de1e7
Markdown Content:
Asset Manager
# Selection
Due Diligence, Active vs. Passive, In -house vs. Outsourced,
Principal -Agent and Fiduciary Duty
> Fernando Forcada, CFA
> Selected Topics, March 2025
## 1Asset Manager Selection
>
Objective : To find the best possible asset manager for a specific
mandate or asset class
>
Most investors do not select securities themselves ; they rely on
managers to select securities for them
>
While most investors are familiar with what makes an investment
attractive (high earnings, growth potential, cheap valuation ), the
process of manager selection is often poorly understood
>
Selecting external asset managers can provide an advantage, especially
in Security Selection and Trade Execution (a source of Alpha
generation )
## 23
Investment
Philosophy
Setting return objectives /
risk profile
Constraints:
Tax
Liquidity needs
Regulation
Liabilities
Time Horizon
Investment Guidelines /
Asset Manager Mandate
Investment
Strategy
&
Investment Policy
Capital Market Expectations
Asset Manager
Selection
Portfolio
Construction &
Security Selection
Trade Execution
Performance
Evaluation &
Compliance
## Investment Process Flowchart
Trade
Settlement&
Booking Asset Manager Selection
Most investors select asset managers only based on two factors :
Low cost
Good track record
But this is not enough :
First, we need to bear in mind the industrys well -known disclaimer : past
performance is not a reliable indicator of future results
And second, cheap active asset managers are still expensive if they do not
provide net excess returns consistently
Investors must decide whether they believe superior managers
exist and whether they can identify them in advance
Over time, empirical evidence has shown that the average managers
performance is in most cases below the benchmark
However, there are also some empirical evidence that suggests that skill
does exist , and many investors have the core belief that there is a minority
group of managers who can be expected to produce Alpha
## 4Key Qualities of Successful
# Managers
Summary of the qualities of successful
managers, according to Warren Buffett,
Jack Treynor and David Swensen :
1. Intelligence : IQ tests, standardized
aptitude exams
2. Knowledge : advanced degrees, the length
and type of work experience, certifications,
and scores on achievement tests
3. Focus : this is difficult to measure but can
be proxied by the number of hours in an
individuals work week
4. Long -term thinking requires formulation
of a strategic process
5. Independent thinking is associated with
self -confidence and self -esteem
6. Alignment of interests : the
compensation scheme for the fund manager 5
Can investors identify
skillful(*) managers to profit
from positive Alpha?
(*)Managers whose success has
been based on their investment
skill (rather than luck) Asset Manager Selection
Large investors that want active management and access to all asset
classes(*) may need to select multiple managers to be able to invest
in particular or niche categories
(*) Small -cap equities, real estate, hedge funds, distressed debt or venture
capital
Therefore, the task of manager selection also involves :
Determining the appropriate weights to give these managers
And how to balance their potential Alphas within the whole portfolio
Additionally, selecting managers for alternative investing is more
complicated (and normally more critical) than for managers of
traditional portfolios
## 6Asset Manager Selection
BUT, before selecting the appropriate manager, we need to decide on two
critical aspects :
1. ACTIVE vs . PASSIVE : Which approach do we prefer, active or
passive management, or a combination of both?
2. IN -HOUSE vs . OUTSOURCING : Do we want to have an in -house
investment team or an outsourced asset manager? If outsourced, which
functions do we still prefer to keep in -house?
## 7Active vs. Passive Management
Passive strategies assume markets are sufficiently efficient and that
active management cannot add value after transaction costs and fees
Passive strategies seek to capture return through exposure to market risk
(systematic risk or Beta) , such as equity risk, duration risk, or credit risk .
These strategies can also look to capture liquidity risk
Active strategies assume markets are sufficiently inefficient that
security mispricings can be identified and exploited (Alpha return )
Inefficiencies can be categorized as :
Behavioral (perceived mispricings created by the actions of other market
participants, usually associated with biases)
Structural (perceived mispricings created by external or internal rules and
regulations)
Note : there is a 3rd option beyond Active or Passive management that has
gained popularity and has grown substantially in AuM over the last
years : Factor Investing (esp . Smart Beta with ETFs)
## 8Active vs. Passive Management
The decision on active or passive management depends on each specific
investment mandate and the type of asset class or portfolio involved in
the decision
An investor may decide to use a passive approach in some markets or
asset classes and an active approach in other markets or asset classes
Depending on the decision on active/passive management, the selection of
the corresponding asset manager will differ
## 9Active vs. Passive Management
Typically, the decision about selecting an active or passive approach is
mainly driven by outperformance expectation (net of cost) :
Cost : management fee and trading costs are higher in active mandates
Outperformance expectation : Active management expects to outperform the
benchmark, while passive management simply expects to replicate it at the
minimum cost
Only a positive excess risk -adjusted return net of expenses
justifies the use of active managers
The arithmetic of active management (*) : before costs, the average manager will
earn average returns
Alternative assets , such as Real Estate, Hedge Funds or Private Equity
are mainly managed under an active approach (lack of benchmark
info and pricing transparency)
(*) If active managers closely represent the entire market, then on average, their performance, gross of fees
and transaction costs, should be close to the market averages
## 10 11 SPIVA Mexico Scorecard Mid -year 2024
> https://www.spglobal.com/spdji/en/spiva/article/spiva -mexico
In our largest and most closely watched
comparison, 65% of all active large -cap
U.S. equity funds underperformed the
S&P 500, worse than the 60% rate observed
in 2023 and slightly above the 64%
average annual rate reported over the
24 -year history of our SPIVA Scorecards
Across asset classes, underperformance
rates typically rose as time horizons
lengthened. Over the 15 -year period
ending December 2024, there were no
categories in which a majority of active
managers outperformed
SPIVA U.S. Scorecard Year -end 2024
> https://www.spglobal.com/spdji/en/spiva/article/spiva -us/
# In -house vs. Outsourced Asset
# Management
There are pros and cons associated with this decision
The primary risks of outsourcing are around the involvement of a
third party, which is not under direct control of the hiring company
The outside party may also have different standards, such as in the areas of
data security or ESG
Insourcing may offer superior control over quality , result in
better coordination
But if Investment Management is not a core function of the company, probably
you better outsource it and focus on your core business
Institutional investors with enough flexibility can take advantage of both
approaches, combining them to have the best of both worlds
## 12 In -house vs. Outsourced Asset
# Management
Several factors should be considered when deciding on whether outsourcing :
Cost efficiency and the size of the investment portfolio : this is a
critical factor (typical in any decision on outsourcing) .
We should assess which is the minimum internal team structure that it is
needed to perform the functions of investment and asset management
In -house teams also need to invest in technical support such as compliance, back -up
systems and disaster recovery . We should consider economies of scale
Access to research and latest technology offered by external managers ,
together with the required skills and knowledge needed to manage a
specific/sophisticated asset class or investment portfolio
Complexity of the investment mandate : An investment portfolio that is
liabilities -driven may be difficult to manage by an external manager if
liabilities are complex and require specific knowledge of local regulations
On the other hand, in the case of much simpler liabilities, such as non -life, or an
assets -only investor with no liabilities, the outsourcing can be done quite easily
## 13 In -house vs. Outsourced Asset
# Management
Operational risk, regulatory risk, investment compliance : There is a delegation
of functions but not of accountability . However, outsourcing may be a (contractual)
protection against some of these risks
Compensation in case of breaches should be clearly stated in the Service Level Agreement (SLA)
HR issues : in -house teams are more engaged and understand the companys culture
and principles . However, sometimes it is difficult to retain or hire staff with the right
expertise as well as developing an appropriate succession plan
Performance track record : Obviously, internal portfolio managers with an
impressive track record at a reasonable cost have much lower probability to be
replaced by an external asset management company, and the other way around
Critical or strategic functions : There are some investment functions that investors
may not want to externalized, such as SAA, ALM or TAA because they are
strategically very important
Control, Governance and other concerns : Portfolio turnover, alignment of
objectives, understanding of the investment strategy and speed of implementation of
strategic or tactical instructions, quality of service and degree of attention from big
asset management firms 14 Manager life cycle process
The main steps in the process of Asset Manager Selection (called
Manager life cycle Process) are :
1. Selecting external asset managers :
Request for Information (RFI) and Request for Proposal (RFP) : questionnaires and
model portfolio help to reduce the list of candidates (quantitative and qualitative data)
Due diligence : on -site visits where analysts and portfolio managers are interviewed
with the objective of validating the information received, testing the knowledge of the
people involved and verifying the systems and resources
Post -selection : negotiation of the contractual conditions and fees, and eventually the
coordination for the transfer of assets portfolio if needed
2. Monitoring manager compliance to investment policy/guidelines :
External asset managers should know and comply with the clients investment
portfolio guidelines . This is essential to ensure alignment with the potential
new managers on the goals and expectations of the investment mandate
## 15 Manager life cycle process
3. Evaluating the (relative or absolute) risk -adjusted performance :
Depending on the objective it can be evaluated against a market benchmark, against a
group of peers with similar investment mandates, against inflation plus a margin
The calculation agent (this should be set in the contract) is normally the external
manager, but the internal investment team must be able to double -check the
calculations
Performance Evaluation does not only mean checking the return of the portfolio
against established benchmarks, but also the performance in the areas of services,
operations, the overall relationship, and fees
4. Taking corrective actions and de -selecting non -successful asset
managers :
Asset managers that do not meet the objectives are usually placed in a watchlist and
some corrective actions are agreed with them
Normally, after some monitoring and a grace period, those managers that continue to
underperform consistently and/or that do not change their behavior or investment
process according to the clients standards are deselected
## 16 Asset Manager Due Diligence
Evaluating an investment manager is a complex and detailed process
that encompasses a great deal more than analyzing investment returns
The objective is to understand how the investment results were
achieved and whether the investment philosophy, process,
people, and portfolio construction satisfy the assumption that past
performance provides some guidance for expected future performance
Due diligence also entails an evaluation of a firms integrity,
operations, and personnel
Due diligence involves both quantitative and qualitative analysis
## 17 Asset Manager Due Diligence
# Quantitative Factors
Performance appraisal captures most aspects of quantitative analysis,
evaluating a managers strengths and weaknesses as measured by
that managers ability to add value to a stated benchmark
Style Analysis : Understanding the managers risk exposures relative to the
benchmark and how they evolve over time . This analysis should identify all
important drivers of return and risk factors
A managers self -reported risk exposures, such as portfolio concentration ,
industry exposure , capitalization exposure , and other quantitative
measures, are the starting point to classify managers by style
The results of the Style Analysis should be consistent with the managers
philosophy and the investment process . If not, the process might not be
repeatable or might be implemented inconsistently
## 18 Asset Manager Due Diligence
# Qualitative Factors
Investment due diligence , which evaluates the managers investment
process
Investment philosophy : The investment manager should have a clear and
concise investment philosophy
People : Trusting that the manager or team possess the expertise and
experience to effectively implement the strategy . What is the level of key
person risk ?
Portfolio Construction : how investment positions are implemented within the
portfolio . Good investment ideas need to be implemented properly
Operational due diligence , which evaluates the managers infrastructure
and firm
Firm : An investment management firm must operate as a successful business
to ensure sustainability
Infrastructure :
A strong back office is critical for safeguarding assets and ensuring accurate reports
The manager should have a robust trading process that seeks to avoid human error
Third -party service providers , including the firms prime broker, administrator,
auditor, and legal counsel should be known and respected 19 Practice Question
## 20 Answer
## 21 Practice Question
## 22 Answer
## 23 Asset Manager Fiduciary Duty
>
An investment fiduciary is any person who has the legal responsibility
for managing somebody else's money and is in a position of trust
>
Standard III .A. of the CFA Institute Code of Ethics and Standards of
Professional Conduct requires that Members and Candidates must
act for the benefit of their clients and place their clients interests
before their employers or their own interests
>
Investment managers have a fiduciary legal responsibility to act in
their investors best interests, regardless of their own, that is, they
should put investor interest first
>
Fiduciaries should understand they will not be judged on the returns
of their portfolio, but on the prudence (and professionalism)
employed in the creation of the returns
## 24 Incentives and The Principal -
# Agent Problem
Compensation structures in asset management : Generally,
investment managers receive two streams of fee revenue :
Management fee is typically a percentage of the AUM and is often
justified by overhead expenses, such as rent, technology infrastructure,
and the payroll
It rewards managers who attract and retain assets, add value, and
benefit from rising markets
Performance fee is the second stream of revenue and generally
represents a percentage of the return created by the manager net of the
management fee
Performance -based fees work to align interests between managers and
investors because both parties share in the results . It is designed to reward
managers with a share of return for their ability to create value
## 25 Incentives and The Principal -
# Agent Problem
Fee structures can influence which managers will be willing to
accept a mandate . They can also strongly affect manager behavior
Empirical evidence indicates a positive correlation between the inclusion
of performance -based fees and higher alphas for mutual funds and
higher risk -adjusted returns for hedge funds (but also potentially provide
an incentive to introduce more volatility and make riskier investments )
Assets are typically sticky, which means that once investors allocate
their assets to a manager, the manager does not need to produce as
high of a return to retain them as to attract them
Empirical evidence suggests that the situation is similar for mutual fund assets .
To motivate such managers to work harder , instituting an incentive fee
determined by future performance may be useful
## 26 Recommendations
>
Do not become a captive client :
The expenses incurred for terminating one manager and hiring another are not
trivial . Asset managers know this (and might take advantage of this )
Political influence from Joint Ventures / related parties (business/strategic partner)
Systems highly interdependent : IT platform compatibility, automated processes for
accounting and settlement procedures
>
Acknowledge that the only way for managers to succeed in the long term is to
do something that is unique, consistent, and cannot be copied
>
Spend time with portfolio managers to ask questions that are relevant
for alpha generation, portfolio construction, and strategy implementation
>
Try to apply both internal and external asset management
approaches within your investment portfolio . You can optimize the
management of your portfolio and will keep asset managers (both internal
and external) motivated by the chance to replace/be replaced by each other
>
Know Your Limitations as manager selector . Many investors do not
have the training or experience to effectively evaluate a managers
investment process . Improve your skills or look for expert advice
## 27 References (I)
>
Manager Selection . Scott D. Stewart, CFA . CFA Institute
Research Foundation, 2013
>
Factors to consider when selecting managers . David Finstad,
Director Hedge Fund Management, OMERS Capital Markets .
Pavilion Advisory Group, 2014
>
The Principal -Agent Problem in Finance . Sunit N. Shah . CFA
Institute Research Foundation, 2014
>
The Science and Art of Manager Selection . White Paper, Wealth
and Investment Management, Barclays, 2015
>
Overview of the Asset Management Industry and Portfolio
Management . Owen M. Concannon, CFA, and Vahan Janjigian ,
PhD, CFA . CFA Institute, 2018
## 28 References (and II)
The implications of passive investing for securities markets .
Vladyslav Sushko , Grant Turner . BIS Quarterly Review, March 2018
Hedge Fund Investing : Manager Selection and Due Diligence .
Michael Kosoff , Head of Hedge Fund Strategies, Merrill Lynch, June
2015
Investment Manager Selection . Jeffrey C. Heisler, PhD, CFA,
and Donald W. Lindsey, CFA . CFA Institute, 2022 .
www .investopedia .com
## 29 Annex Example of Fee Structure
Comparison of a Standard Fee (0.50 %) and a Performance -Based Fee
schedule, showing the Base Fee and Minimum and Maximum Sharing .
Breakeven active return : 1.50 %
## 30 Standard Fee 0,50%
vs.
Base Fee 0,25%
Sharing 1 20%
> 1)
Calculated on active returns greater than the base fee
Maximum annual fee 0,75% 1 2 3 4 5 6 7 8 9Active Return -0,25% 0,00% 0,25% 1,00% 1,50% 2,00% 2,75% 3,00% 5,00% Billed Fee 0,25% 0,25% 0,25% 0,40% 0,50% 0,60% 0,75% 0,75% 0,75% Active Return Net of Fee -0,50% -0,25% 0,00% 0,60% 1,00% 1,40% 2,00% 2,25% 4,25% Annex Example of Fee Structure
Performance -based fees are structured in one of three basic ways :
A symmetrical structure in which the manager is fully exposed to both the
downside and the upside : The computed fee equals the base fee plus sharing of
performance
A bonus structure in which the manager is not fully exposed to the
downside but is fully exposed to the upside : The computed fee equals the higher
of either (1) base fee or (2) the base fee plus sharing of positive performance
A bonus structure in which the manager is not fully exposed to the
downside or upside : The computed fee equals the higher of either (1) the base fee
or (2) the base fee plus sharing of performance, to a limit
Private equity, hedge fund, and real estate partnerships commonly
earn performance fees on total returns and typically do not limit the
amount of the performance fee
## 31 Annex - Management Fees
## 32
Investors are increasingly sensitive to management fees
The average expense ratio (management fees and fund expenses) of
actively managed equity mutual funds has declined from 1.06 % in
2000 to 0.82 % in 2016 (*)
The average expense ratio of actively managed bond mutual funds
has declined from 0.78 % in 2000 to 0.58 % in 2016 (*)
(*) Source : ICI Investment Company Fact Book, 2017 Annex Incentives and The
# Principal -Agent Problem
Under a principal/agent duty, an agent is legally appointed to act on behalf
of the principal without conflict of interest . Investors hire portfolio
managers to act as their agents
Investors want managers who are highly skilled, diligent, and persistent, but
they also want managers whose interests are aligned with their own,
that is, in investors best interests
Investors generally cannot perfectly monitor the level of effort the
managers put forth, and asset -level detail on where their funds are
placed is often either unavailable or costly to acquire
Consequently, if an investors incentives are not aligned with those of the
manager, the manager often has both an incentive to act counter to
the investors best interests and the ability to do so undetected
Given the magnitude of payment generally involved in asset management
contracts, misaligned incentives have significant potential to override
a managers fiduciary responsibility
## 33 Annex Asset Management Industry
Asset management clients are broadly divided among individual (or retail)
and institutional :
Asset managers who focus on individual investors typically package
investment strategies through highly regulated pooled vehicles (mutual
funds or ETFs) and distribute their products directly to investors through financial
advisers and/or retirement plans
Institutional -focused managers typically package their investment
strategies in less regulated and more customizable product structures
(separately managed accounts and limited partnerships) . Institutional investors
include several major segments : pension plans, sovereign wealth funds, banks, or
insurance companies
The asset management industry is evolving and continues to be shaped by
socio -economic trends, shifting investor demands, advances in technology,
and the expansion of global capital markets . Main trends affecting the
industry are :
Index Investing (ETFs) More details in following classes
Factor Investing (Smart Beta ) More details in following classes
Mega -trend Investing (disruptive global forces that may change the world in the long
run) More details in following classes
Big data in the investment process More details in following classes
Robo -advisers in the wealth management industry More details in following
classes
## 34 Annex Tips for a successful
# manager search
Features of a successful manager search (based on Scott D.
Stewarts book Manager Selection) :
1. Define goals for the mandate , including active risk
2. Determine which specialized skills are available internally and which
are needed to select quality managers ; apply the expertise of others if not
available inhouse
3. Document transaction costs, management fees, and costs of manager
turnover , and then determine the level of added value required to cover
them ; determine the managers commitment to hold assets at that level
4. Prepare questions to review the managers philosophy, resources,
and culture
5. Document the managers investment process ; confirm that portfolio
characteristics and performance match the stated process and make sense
6. Explore fee arrangements , including details of performance sharing
7. Define measures of success for the manager ; specify the time period for
which the manager will be evaluated and agree on the objectives
## 35 Annex Asset Management Industry
Large Asset Managers : They are full service managers that typically
offer a wide variety of asset classes and styles . Given the pressure in
margins, economies of scale are becoming more important . This is
particularly important in index investing, but active asset managers do not
get better when they get bigger . Moreover, staff may lose its sense of
ownership of the firm, motivation usually drops, the corporative culture
changes and the shared vision fades
Boutique asset managers : They are smaller firms in the financial
segment that prosper by positioning themselves to serve a specific niche, that
is, they specialize by industry, client asset size, market or asset class to
manage a segment not well addressed by larger asset managers
Historically, boutique firms have outperformed their market benchmarks and non -
boutique asset managers . Entrepreneurship characterizes the culture of many
boutique firms, which attracts talented investors and portfolio managers
Multi -boutique model refers to the concept of a number of small boutique
investment firms that sit under the umbrella of a larger company
They benefit from the centralized, shared services of the holding company
(distribution channel, robust and cost -efficient compliance/governance system,
technology, legal services ), while still keep their manageable size and advantages
of being boutique investment managers
It allows individual asset management firms to retain their own unique investment
cultures, and often equity ownership stakes
## 36 Annex Asset Management Industry
Nearly 80 % of the
worlds professionally
managed assets are in
North America and
Europe, but the fastest -
growing markets are
in Asia and Latin
America
## 37
> Source: Boston Consulting Group and CFA Institute. Data as of year -end 2016
Global AuM by Region
Global Asset Management Industry Assets and Revenue
> Source: Boston Consulting Group and CFA Institute. Data as of year -end 2016
Active management
considerably exceeds
passive management in
terms of global AuM
(and industry revenue),
but the passive
management growth
over the last years
has been impressive Annex - Ownership Structure
>
The ownership structure of an asset manager can play an important
role in retaining and incentivizing key personnel
>
Moreover, portfolio managers who have personal capital invested in
their firms or investment strategies (skin in the game) are often
viewed favorably by potential investors because of perceived alignment
of management and client interests
>
The majority of asset management firms are privately owned .
Publicly traded asset managers are considerably less common but have
substantial assets under management, that is, most of the major
investment firms are publicly traded
>
Another important form of ownership form in the industry is represented
by asset management divisions of large, diversified financial
services companies that offer asset management alongside insurance
and banking services
## 38