Components of a Manager Selection Process

Manager Universe

Defining the Universe: What is the set of managers that best fits the portfolio's needs?

• Suitability: Which managers are suitable/permitted under the IPS?
• Style: Which style fits?
• Active vs passive

Quantitative Analysis

Investment Due diligence

• Attribution and appraisal: Has the past manager operated with skill?
• Capture ratio: How do bull and bear markets affect manager performance?
• Drawdown: Is the manager subject to large drawdowns?

Qualitative Analysis

• Philosophy: Can the manager be expected to continue their return? What inefficiency of the market does the manager seek to exploit?
• Process: Will the process work given the managerial philosophy?
• People: Do the employees have expertise?
• Portfolio: Is the current portfolio consistent with the investment team's investment philosophy, advertising, and processes?

Operational and Due Diligence

• Firm: Does it have a profitable business model, a healthy culture, and a good chance of staying in business? Is the firm committed to performing versus just gathering assets?
• Process and procedures: Does the admin team function smoothly and generate timely and accurate reports? Does the firm secure the assets efficiently?
• Investment Vehicle: Are investments suitable given IPS restrictions?
• Terms: Do the contractual terms match needs and restrictions?
• Monitoring: Is the process continual? Does the manager still best fit the portfolio needs?

Manager Universe – Expanded

The initial search for a manager will likely yield far too many options, more than could be given proper consideration. This search will need to be filtered given a set of criteria deemed important to the researchers. If the list of managers is still too broad or too narrow, the search criteria can be adjusted to yield an appropriate amount of search results.

An important consideration will be the IPS. If the IPS does not allow for active management, this must be reflected in the initial search criteria. A search for passive managers will be the initial filter, and more criteria will be added subsequently. A search will often begin with a benchmark that represents the manager's role within the portfolio. The benchmark also provides a reference for performance attribution and appraisal. There are several approaches to assigning a manager to a benchmark:

• Third-party categorization: There are many third-party data vendors who offer the service of manager categorization. This can be a convenient option, only in that it comes with the risk that the definitions used by the vendor and the fund may differ.
• Returns-based style analysis: Although this process can be somewhat time-consuming and complex, a returns-based analysis can reveal a manager's style by indicating where previous returns have come from.
• Holdings-based style analysis: This approach allows for the analysis of current factor exposures but adds to computational effort and depends on timing and amount of transparency.
• Manager experience: The assessment relies on the researcher's expertise in categorizing managers. It's centered on evaluating the manager, portfolio, and returns using the researcher's knowledge and experience.

Not surprisingly, a hybrid strategy that combines elements of each approach is often used and recommended. It is important to note that initially, the screening should avoid using performance. The focus at this point is on understanding the manager's risk profile and identifying appropriate candidates. Lastly, the final step in the selection process cannot be understated. Selecting a manager is important, but it is a dynamic problem and needs to be properly monitored over time as circumstances inevitably change.

Question

Performance monitoring is a part of which phase of investment manager selection and due diligence?

1. Manager universe.
2. Qualitative analysis.
3. Quantitative analysis.

Solution

The correct answer is C.

Performance monitoring is a crucial part of the quantitative analysis phase. Quantitative analysis focuses on analyzing the historical performance of the investment manager's strategies, comparing it to relevant benchmarks, and assessing risk metrics. It involves looking at performance data and financial metrics to determine how the manager has performed in the past.

A is incorrect. It refers to the initial step where a broad pool of potential investment managers is identified and screened. This phase involves compiling a list of potential managers, and performance monitoring does not take place at this stage. Performance monitoring is typically conducted after the manager has been selected and investment activities are underway.

B is incorrect. Qualitative analysis involves evaluating non-numeric factors like the manager's investment philosophy, team, process, and compliance with regulations. While performance can be part of the qualitative analysis discussion, it is not the primary focus of this phase. Performance monitoring usually occurs after the qualitative analysis is completed.

Performance Measurement: Learning Module 2: Investment Manager Selection; Los 2(a) Describe the components of a manager selection process, including due diligence