Manager selection

What Is Manager Selection?

Manager selection is the comprehensive process by which investors, institutions, or financial advisors identify, evaluate, and choose professional investment managers to oversee a portion or all of an investment portfolio. This crucial aspect of portfolio management falls under the broader category of investment strategy and aims to align the manager's capabilities and investment style with the investor's specific investment objectives and risk tolerance. Effective manager selection requires extensive due diligence to assess various quantitative and qualitative factors, ensuring the chosen manager is well-suited to achieve the desired financial outcomes within acceptable risk parameters.

History and Origin

The practice of manager selection evolved alongside the growth of institutional investing and the proliferation of professional asset managers. In the mid-20th century, as pension funds, endowments, and foundations grew in size and complexity, the need for specialized expertise in managing vast sums of capital became apparent. Initially, the process might have been less formalized, relying more on reputation and personal networks. However, as the investment landscape became more competitive and academic research, such as the efficient market hypothesis, challenged the consistent outperformance of active management, the methodology for choosing managers became increasingly rigorous. Regulators also played a role in standardizing oversight; for instance, the U.S. Securities and Exchange Commission (SEC) provides extensive guidance and registration requirements for investment advisers, underscoring the importance of proper vetting in the financial industry.⁴

Key Takeaways

• Manager selection is the process of evaluating and choosing professional investment managers.
• It involves comprehensive due diligence, considering both quantitative metrics and qualitative aspects.
• The goal is to align a manager's expertise with an investor's specific objectives and risk profile.
• Successful manager selection aims to identify managers capable of generating desirable risk-adjusted returns.
• The process is continuous, involving ongoing monitoring of performance and adherence to investment guidelines.

Interpreting the Manager Selection

Interpreting manager selection goes beyond simply reviewing past performance figures. While a manager's historical returns are a starting point, a deeper analysis considers whether those returns were achieved through skill or merely luck. Investors scrutinize factors like the consistency of alpha generation, the manager's adherence to their stated investment process, and the manager's fee structure. It is crucial to understand the manager's investment philosophy and how it aligns with the client's asset allocation strategy. A manager who performed well in a specific market cycle may not necessarily perform well in different conditions, highlighting the need for a forward-looking assessment of their adaptability and strategy.

Hypothetical Example

Consider an institutional investor, Endowment Alpha, seeking to add a global equity component to its portfolio. Endowment Alpha's investment policy statement dictates a long-term growth objective with a moderate risk tolerance.

The manager selection process begins with screening a universe of global equity managers based on initial criteria, such as assets under management, years in business, and minimum performance hurdles relative to a relevant benchmark. This narrows down hundreds of potential candidates to a shortlist of ten.

Next, Endowment Alpha's investment committee conducts in-depth due diligence on the shortlisted managers. They analyze each manager's investment team, organizational structure, compliance record, and proprietary research capabilities. For quantitative analysis, they evaluate historical returns over multiple market cycles, scrutinize portfolio concentration, and assess various risk metrics. They discover Manager X has consistently generated positive alpha, with lower volatility than its peers, and a transparent investment process focused on fundamental research. Manager Y, while having higher peak returns, exhibits inconsistent performance and a less defined strategy. Ultimately, after extensive interviews and reference checks, Endowment Alpha chooses Manager X, concluding that their disciplined approach and alignment with the endowment's long-term philosophy make them the better fit.

Practical Applications

Manager selection is a critical practice across various facets of the financial industry:

• Institutional Investing: Pension funds, endowments, foundations, and sovereign wealth funds employ sophisticated manager selection processes to allocate capital across diverse asset classes and investment vehicles.
• Wealth Management: Financial advisors perform manager selection for individual clients, tailoring portfolios to meet personal financial goals, such as retirement planning or wealth accumulation. They often choose between various mutual funds, exchange-traded funds (ETFs), or separately managed accounts.
• Fund-of-Funds and Multi-Manager Strategies: Investment products structured as fund-of-funds inherently rely on a rigorous manager selection process to identify underlying managers that will collectively achieve the product's objectives.
• Consulting Firms: Investment consulting firms specialize in manager research and selection, advising institutional clients on optimal manager lineups and ongoing oversight.
• Regulatory Oversight: Regulatory bodies like the SEC examine investment advisers, including their processes for manager selection, to ensure they fulfill their fiduciary duty to clients. The North American Securities Administrators Association (NASAA) provides guidance for investment advisers, emphasizing due diligence in this area.³

Limitations and Criticisms

Despite its importance, manager selection faces several inherent limitations and criticisms:

• Performance Persistence: A significant challenge is the lack of consistent evidence that past performance predicts future results. Studies, including those cited by Northern Trust, often find limited performance persistence in manager outperformance, especially after accounting for fees and trading costs.² This suggests that identifying a manager who can consistently beat a benchmark is exceptionally difficult.
• Survivorship Bias: Performance databases often suffer from survivorship bias, meaning that poorly performing or closed funds are removed, artificially inflating average returns and making manager selection appear more successful than it is in reality.
• Data Mining: The vast amount of available data can lead to data mining, where investors inadvertently identify patterns in historical data that are coincidental rather than indicative of true manager skill.
• High Fees: Actively managed funds, which are typically the subject of manager selection, often come with higher fees compared to passive investment options. These higher costs can significantly erode any potential outperformance, making it challenging for active managers to justify their fees. Morningstar research indicates that a low percentage of active managers consistently outperform their passive counterparts over extended periods, particularly in efficient markets.¹
• Behavioral Biases: Investors involved in manager selection can be subject to behavioral biases, such as recency bias (favoring managers with recent strong performance) or confirmation bias (seeking information that confirms pre-existing beliefs about a manager).

Manager Selection vs. Active Management

While closely related, manager selection and active management are distinct concepts. Active management refers to an investment approach where a portfolio manager makes specific investment decisions (e.g., buying, selling, or holding securities) with the aim of outperforming a particular market index or benchmark. The manager actively seeks to generate alpha through security selection, market timing, or other strategies, rather than simply replicating an index.

Manager selection, on the other hand, is the process of choosing an active manager (or, less commonly, a passive manager based on their ability to track an index efficiently). An investor engages in manager selection when they decide to entrust their capital to a professional who employs an active management strategy. The success of an active management strategy depends on the manager's skill, while the success of manager selection depends on the investor's ability to identify truly skilled managers among many contenders. In essence, active management is the strategy, and manager selection is the method of choosing the practitioner of that strategy.

FAQs

Q1: Is manager selection only for large institutions?

No, while large institutions often have dedicated teams for manager selection, individual investors and financial advisors also engage in this process when choosing mutual funds, ETFs, or wealth managers for their portfolios. The principles of due diligence apply regardless of scale.

Q2: How important is past performance in manager selection?

Past performance is a starting point for analysis but should not be the sole determinant. It's essential to understand the sources of past returns, whether they were driven by a repeatable process or favorable market conditions. Focus should be on risk-adjusted returns and the consistency of the manager's strategy.

Q3: What is the role of fees in manager selection?

Fees are a crucial consideration. Higher fees can significantly erode returns, making it harder for an active manager to deliver net-of-fee outperformance. A thorough manager selection process evaluates the fee structure relative to the value added and the competitive landscape.

Q4: Does manager selection apply to passive investing?

While less emphasis is placed on "skill" in passive investing, manager selection is still relevant. For passive investment vehicles like index funds or ETFs, the selection process focuses on factors like tracking error (how closely the fund tracks its benchmark), expense ratios, liquidity, and the reputation of the fund provider.

Q5: What is a fiduciary duty in manager selection?

When an investment professional undertakes manager selection on behalf of a client, they generally have a fiduciary duty. This means they are legally and ethically obligated to act in the client's best interest, prioritizing the client's needs above their own. This includes performing thorough due diligence and selecting managers deemed most appropriate for the client's investment objectives.