The manager selection process is a critical step in constructing and maintaining a portfolio that aligns with the investment policy statement (IPS). It involves rigorous due diligence to evaluate whether an investment manager can consistently achieve the desired returns while adhering to the portfolio’s objectives and constraints. Here’s a detailed breakdown of the components:
1. Manager Universe
Objective:
To narrow down a broad pool of managers to a focused group that aligns with the portfolio’s IPS, investment style, and risk tolerance.
Key Steps:
- Define the Role:
- Determine the manager’s intended role within the portfolio.
- Identify the benchmark that will guide their performance and style.
- Identify Relevant Style:
- Managers must match the portfolio’s desired style (e.g., value, growth, balanced).
- They must balance active vs. passive management approaches as per the IPS.
- Use Benchmarking Tools:
- Third-Party Categorization: Databases and software providers can help classify managers by style and strategy, though their definitions may not fully align with portfolio needs.
- Style Analysis:
- Returns-Based: Analyzes historical performance relative to style benchmarks.
- Holdings-Based: Examines the actual securities held to determine the manager’s style and consistency.
- Manager Experience: Assesses the manager’s track record through past holdings and returns.
Focus:
At this stage, performance is not the focus. Instead, emphasis is placed on the manager’s risk profile and suitability for the portfolio’s objectives. The manager universe should be dynamic, as strategies and managers evolve.
2. Quantitative Analysis
Objective:
To objectively evaluate the manager’s historical performance and identify whether it was driven by skill or luck.
Key Methods:
- Performance Attribution and Appraisal:
- Disentangle returns attributable to market conditions from those due to the manager’s decisions.
- Capture Ratios:
- Measure performance during both up and down markets to evaluate how well the manager performs in varying conditions.
- Drawdowns:
- Examine significant peak-to-trough declines to assess risk exposure and resilience during downturns.
3. Qualitative Analysis
Objective:
To assess the likelihood of the manager replicating their performance and the robustness of their investment process and organization.
Key Components:
- Four Ps:
- Philosophy:
- Focuses on the manager’s market inefficiency hypothesis and strategy to exploit it.
- Process:
- Evaluates the feasibility and rigor of the investment process.
- People:
- Reviews the knowledge, skills, and stability of the team managing the portfolio.
- Portfolio:
- Ensures the portfolio construction aligns with the philosophy and process.
- Philosophy:
- Risk Assessment:
- Firm Viability:
- Assesses the firm’s financial health and ability to sustain operations.
- Operational Due Diligence:
- Investigates back-office quality, asset safeguarding, and the ability to generate timely and accurate reports.
- Investment Vehicle Suitability:
- Ensures the vehicle matches portfolio requirements and contractual terms align with the strategy.
- Firm Viability:
4. Ongoing Monitoring
Objective:
To ensure the manager continues to meet the portfolio’s needs and objectives over time.
Key Activities:
- Regularly review the manager’s performance and adherence to the investment process.
- Monitor any changes in the manager’s organization, philosophy, or investment environment that could affect their suitability.
Type I and Type II Errors in Manager Hiring and Continuation Decisions
When evaluating investment managers for hiring, retention, or termination, hypothesis testing is often used to assess whether a manager adds value. Errors in this process are categorized as Type I and Type II errors.
1. Definitions and Context
- Null Hypothesis (H₀): The manager adds no value (i.e., no skill).
- Type I Error: Rejecting the null hypothesis when it is true.
- Interpretation: Hiring or retaining a manager who does not add value (no skill).
- Type II Error: Failing to reject the null hypothesis when it is false.
- Interpretation: Not hiring or firing a manager who actually adds value (has skill).
Summary Table of Errors
| Realization | Below Expectations (No Skill) | At or Above Expectations (Skill) |
|---|---|---|
| Decision: Hire/Retain | Type I Error | Correct |
| Decision: Not Hire/Fire | Correct | Type II Error |
2. Characteristics of Errors
Type I Errors
- Represent errors of commission (an active decision that results in explicit costs).
- More visible and measurable (e.g., underperformance relative to a benchmark).
- Impact:
- Retaining weak managers leads to underperformance and potential financial losses.
- Affects decision-maker credibility and compensation.
- Easily noticed by clients and stakeholders.
Type II Errors
- Represent errors of omission (a passive decision that results in opportunity costs).
- Less visible and harder to measure (e.g., how a non-hired manager might have performed).
- Impact:
- Not hiring or firing strong managers leads to missed opportunities for alpha.
- Difficult to track and justify, especially to clients.
3. Preventing Errors
Reducing Type II Errors
- Track Performance: Monitor the subsequent performance of non-hired or fired managers.
- Assess Selection Criteria: Compare characteristics of hired/retained managers versus those who are not.
- Focus on Long-Term Performance: Avoid making decisions based on short-term results or behavioral biases.
- Refine Processes: Ensure selection processes align with portfolio investment objectives and emphasize a holistic evaluation.
Balancing Error Costs
- The cost of retaining weak managers (Type I) must be weighed against the cost of missing strong managers (Type II).
- Minimize errors by increasing the dispersion between strong and weak manager performance:
- Use comprehensive evaluation metrics to distinguish skills clearly.
- Favor environments with higher performance variability between managers.
4. Costs of Errors
Type I Errors
- Costs stem from retaining managers who fail to deliver value.
- More likely to occur when:
- Markets are mean-reverting, where poor performance might later improve.
- Decision-makers rely heavily on past short-term performance.
Type II Errors
- Costs arise from not hiring or firing managers who could have added value.
- More likely to occur when:
- Markets are mean-reverting, where strong performance may later falter.
- Decision-makers overlook long-term potential due to short-term underperformance.
5. Market Efficiency and Error Costs
- Efficient Markets: Lower return dispersion between managers makes it harder to identify strong managers, reducing Type II error costs.
- Mean-Reverting Markets: Greater potential for:
- Type I Errors: Hiring or retaining managers whose performance deteriorates after selection.
- Type II Errors: Failing to hire or firing managers who subsequently outperform.
Conclusion
Type I errors are typically more visible and receive greater attention due to their measurable impact on performance and decision-maker accountability. However, excessive Type II errors can signal flaws in the hiring and retention process, potentially leading to significant opportunity costs. A balanced and objective evaluation process that incorporates both quantitative and qualitative metrics is essential to minimize these errors and optimize portfolio performance.
The manager selection process combines quantitative rigor with qualitative insight to identify managers who are both capable and aligned with the portfolio’s objectives. This comprehensive approach ensures a robust and sustainable alignment between portfolio requirements and manager capabilities, with continual monitoring to adapt to changes in market conditions or manager performance.
