To effectively monitor an investment manager, investors must put in place a methodical process. In fact, it is part of their fiduciary duty to their stake holders to do so. Unfortunately the result of our global industry survey reveals that most investors have varying degrees of deficiencies in their programs. Some investors have no structured follow-up and often purposely mislead by claiming that they have one. Almost equally as awful, is that some investors view monitoring merely as an ex-post performance assessment exercise that is heavily influenced by feedback received from their investment committee. Make no mistake, monitoring is imperative and complacency around it can lead to sub-optimal and even devastating outcomes. To increase the likelihood that optimal long-term returns are achieved, investors need to adopt a rigorous monitoring process that incorporates the qualitative virtues of operational due diligence and the objectivity of quantitative analysis. Moreover, the process should relentlessly strive to achieve the highest standard. Proper monitoring requires an assessment as to whether the manager continues to possess all of the attributes that attracted the investor to make his initial investment.
Put Your Detective Hat On! It is Time to Qualify Our Ownership
A chief objective of qualitative monitoring is to provide investors with a defined process that assists to identify how things have evolved from their previous assessment of the manager’s organization and investment process, and whether risk levels could be raised. The qualitative component of monitoring investment managers involves cross-referencing gathered information against a pre-determined checklist. This analysis involves due diligence captured from on or off site manager meetings, the compilation of certain filings as well as the perusal of various news sources.
The monitoring checklist needs to be comprehensive and thus commensurate with such rigor expected of an institutional investor. Among the list of items should include:
- Any alteration to the firm’s ownership and remuneration structure
- Any changes to key personnel across the organization and not exclusive to the front office
- Operational and market-related constraints that could prevent the expansion of assets under management
When interviewing, investors should ensure that the manager is forthcoming with his answers. Managers that are not, no matter how large their firms are, should be overlooked in deploying a portion of their capital. To be clear, it is common practice that large, reputable managers provide canned responses to investor questions leaving the investor without any additional insight. Should an investor feel that they are unable to receive satisfactory answers to basic questions, it is their duty not to invest with these managers. In reality, more often than not, many investors adopt a herd mentality and allocate their capital to the same managers that everyone else does in order to avoid taking on the career risk associated with going out on a limb by investoring with an emerging manager.
The depth of monitoring is likely to differ depending on the length of time that the investor has a relationship with the manager. Certainly in the early years there is more client servicing whereby the investor has a greater need to touch base with the manager in regards to his view of the market, insights into investment process and specific holdings as well as overall portfolio positioning. Collectively, the qualitative analysis can serve as a leading indicator of future performance issues and complements the analysis of performance reporting, which only looks at historical returns.
Style-based analysis is used to illustrate how asset growth can impact portfolio style and result in return dilution. As a manager’s assets grow his need for liquidity also increases. He can address this need by moving capital away from small and mid cap stocks that are less liquid. In turn, he gravitates his portfolio to more liquid, larger cap stocks. There is also a tendency to over-diversify with additional holdings. These two counter measures end up calling into question a manager’s ability to deliver returns that are consistent with historical results. In fact, returns are less likely to perform as well given the portfolio’s lower-risk orientation.
Emotions Need to be Kept in Check When Analyzing Quantitative Metrics
When it comes to the use of investment manager quantitative markers, three items must be established from the outset:
- Return Target
- Risk Target
It is well-documented that markets can overreact in the short-term but normalize over the course of a full investment cycle which incorporates a variety of market environments. In the short term, it is easy to mistake manager luck for skill. As well, return targets can be particularly low and risk can easily fall outside established bands. In these moment investors must keep their emotions in check when assessing quantitative metrics. If not, they can get caught up in the euphoria of market moments leading to decisions that defy rational thought.
Favouring managers that have outperformed over those that have under-performed is a classic investor peave (Goyal and Wayal, 2008). Investors need to understand the market environment when portfolio results are achieved. An investor should be mindful of how a manager’s style may have helped or hurt during a specific market. For instance, if a manager was overweight high-beta resources stocks in 2009 and 2010 when the market rallied significantly, the discussion needs to quickly turn to how the manager performed in a far less directional market.
When active risk is low (i.e. managed close to the benchmark), performance monitoring should be conducted more frequently. This is because a passively managed portfolio is expected to exactly match the returns of an index. In essence, there is no margin for error under these circumstances. In contrast, a long-term, actively managed portfolio should not place too much emphasis on short-term results. For instance if a pension fund were to place too much emphasis on short-term returns they would likely experience unfavorable results derived from transitioning away from a weaker performing manager in favor of stronger one (i.e. selling low and buying high).
The two questions that have to be answered are:
- Did I make money (absolute)?
- How well did I perform relative to a passive comparable benchmark?
As such, investors should customize a portfolio return based on their own, unique risk tolerances and customize a benchmark that best fits the strategy in place.
For those investors looking to analyse their return versus the risk taken, they are urged to use Information and Sharpe ratios. Plotting the related results on scatter diagram provides a useful visual of how certain managers compare with others as well as how they compare to the market as a whole from a risked-return perspective.
Manager selection consultants are very helpful at providing investors with a short list of managers. With these managers in hand, the investor needs perform its selection based on its proprietary process. All the while investors need to be fully aware that there are periods in the market when it becomes more challging for a manager to add value. These include periods of high-stock correlation (mostly for relative managers) and low stock volatility (mostly for absolute managers)..
Peer Group Comparisons Need to be Adjusted for Manager Biases to be Useful
Institutional investors are large proponents of simplicity such as easy-to-use checklists and comparable tools. They often use categorization to mean that all related managers are in fact peers. In fact, finding comparable peers is very difficult and often times managers with a lower risk mandate are compared against managers with a high risk mandate. There is no ranking to display how well managers have implemented their investment philosophy and approach. To effectively monitor, this becomes the job on the investor.
Overlaying biases in the quantitative analysis process will assist the investor to appreciate that a manager is likely to under-perform under certain conditions. So that when biases are not rewarded during a particular market period, it does not mean that the manager’s skill has diminished.
Replacing a manager is costly. It is not very often that investors can make an economic argument for changing their managers. In essence, the expected excess return of investing with a new manager must exceed the costs associated with making a move. Benefits are achieved from manager skill delivered over a long period of time. Whereas the costs are immediate. Therefore, there is a pronounced timing misalignment. Moreover, this cost-benefit model involves a prediction that is very difficult to quantify and with a very strong chance of being incorrect. The associated costs are linked to:
- Brokerage Fees
- Capital gains taxes
- Market impact costs
- Opportunity cost of being uninvested for a period of time
- Type II error whereby you fired a manager that subsequently outperforms
Investors can fire a manager at the worst possible time should their emotions drive their decision. And though the economics to change managers for the most part make little sense, it is the non-sensicality of human behaviour that nevertheless drived these decisions to be made. Some more credible reasons for making manager changes include avoiding reputational risk, heighened operational risks and poorly aligned incentives.
Performance analysis addresses style drift, whereby either the strategy is no longer suitable for the investor. Or, the manager is in fact no longer meeting its stated investment style and philosophy.
Investors need to drive their own methodical monitoring process. They may work with a consultant that has more extensive experience at developing a process and establishing operational due diligence programs. The risk of not having such a foundation in place will be costly over time the result of sub-optimals decisions. Uncecessary costs will most likely be realized driven by both known and unknown exessive risks.
Topics in Investment Manager Selection, Jeffrey C. Heisler, Ph.D, CFA and Jeffrey Nipp, CAIA, CFA, CFA Institute, 2016.