Investment Philosophy
The investment philosophy forms the foundation of a manager’s investment process. A robust evaluation focuses on understanding how the manager perceives market behavior and the rationale behind their chosen approach. Below are the key aspects:
1. Passive vs. Active Strategies
- Passive Strategies:
- Premise: Markets are highly efficient, and active management is unlikely to outperform after costs.
- Objective: Earn risk premiums by targeting systematic risks (e.g., equity, credit, liquidity, volatility).
- Implementation: Use index funds or ETFs to replicate market performance while minimizing costs.
- Active Strategies:
- Premise: Markets are inefficient, allowing for opportunities to exploit mispricings.
- Objective: Generate alpha by identifying securities whose market prices deviate from intrinsic value.
- Implementation: Rely on research, timing, and skill to outperform benchmarks.
2. Sources of Inefficiencies
- Behavioral Inefficiencies:
- Result from investor biases (e.g., herd behavior, overreaction).
- Tend to be short-term, requiring quick exploitation.
- Example: Capitalizing on momentum or contrarian signals.
- Structural Inefficiencies:
- Stem from laws, regulations, or market constraints.
- Tend to be long-term, offering more sustainable opportunities.
- Example: Exploiting tax advantages, regulatory limits, or niche markets.
3. Assessment of the Philosophy
- Clarity and Logic:
- Is the philosophy clearly articulated, logical, and internally consistent?
- Do the assumptions make sense given the manager’s strategy?
- Congruence with Process:
- Is the philosophy aligned with the actual investment approach (e.g., belief in inefficiency with active strategies)?
- Consistency:
- Has the philosophy remained stable over time?
- Are changes driven by rational adaptation to market shifts or reactionary responses to short-term performance?
4. Informational vs. Structural Advantage
- Informational Advantage:
- Short-term in nature.
- Depends on accessing or processing information faster than competitors.
- Less repeatable and more prone to erosion as competitors catch up.
- Structural Advantage:
- Long-term in nature.
- Arises from regulatory or institutional frameworks.
- More sustainable and repeatable over time.
Capacity Evaluation
Capacity measures the ability to generate sufficient excess returns while accounting for operational constraints. This includes:
1. Economic Feasibility
- Does the inefficiency generate returns sufficient to cover:
- Transaction Costs: Costs of executing trades.
- Management Fees: Fixed and performance-based fees.
- Leverage Costs: If leverage is used, are borrowing costs manageable?
2. Repeatability
- Is the inefficiency consistent and likely to persist, or is it a one-time anomaly?
- Does the manager have the skill and resources to identify and exploit it repeatedly?
3. Sustainability
- Market Depth and Liquidity:
- Can the market absorb large trades without significant price impact?
- Is liquidity sufficient to enter and exit positions efficiently?
- Scalability:
- Is the inefficiency large enough to accommodate growth in assets under management (AUM)?
- At what point does additional capital dilute returns?
Questions for Evaluation
- Philosophy and Process:
- Does the manager’s philosophy align with their investment approach?
- Is the philosophy well-reasoned, consistent, and adaptive when necessary?
- Market Assumptions:
- Does the manager assume markets are efficient or inefficient?
- Are the identified inefficiencies supported by evidence?
- Risk and Return:
- How does the philosophy address risk management while targeting excess returns?
- Are diversification and risk controls integral to the process?
- Sustainability:
- Can the strategy sustain its performance as AUM grows?
- Are transaction costs, fees, and market liquidity adequately considered?
By thoroughly evaluating a manager’s investment philosophy and decision-making process, investors can determine the manager’s suitability, sustainability, and potential for delivering long-term value. 
