Top-down Strategies
Instead of picking individual stocks, top-down managers use broad market ETFs and contracts... Read More
Assessing potential managers' investment philosophy and decision-making process serves as a risk mitigation strategy. Allocators aim to gain insights not only into the manager's past investment performance but also how it was achieved, the underlying processes, and its potential repeatability. The goal is to determine whether the investment philosophy, processes, team, and portfolio construction support the idea that past performance can offer guidance on future expectations. Subsequent sections will provide more in-depth information on this evaluation process.
Broadly speaking, managers may fall into active or passive investment categorizations. A manager who is passive believes that markets are efficient, and seek to earn their returns via risk-premiums – a factor or set of factors that earns a return in addition to the risk-free rate for bearing a risk that is not easy to diversify. These risks could include:
These strategies can also look to capture alternative risk premiums including:
Active managers conversely believe that markets are sufficiently inefficient that securities mispricing is common and may be found and exploited for gain. These inefficiencies (the incorrect valuation of securities by the market) are generally labeled as structural or behavioral.
Active strategies rely on assumptions about market dynamics and structures, including:
Understanding these assumptions and their role in the investment process is crucial for assessing how a strategy performs over time and in different market conditions.
Expertise is a prerequisite for investment success, especially for managers with experience in their current investment strategy. Here are other essential questions and considerations:
Investment management agreements will be covered in further detail in another section summary.
The investment decision-making process is comprised of four elements: signal creation, signal capture, portfolio construction, and portfolio monitoring.
Signal creation is the foundation of trade decisions, and it should possess three key qualities:
After deciding on a signal creation idea, allocators should want to know who is responsible for making a trade happen and approving trade ideas. Also, how are ideas translated into new trades and positions? As always, allocators want to uncover whether this system is robust and repeatable.
This phase delves into risk management. Allocators seek insights into how the portfolio is assembled and whether positions complement each other, capturing diversification benefits.
Another important consideration is liquidity. Allocators will want to understand whether the portfolio attempts to capture liquidity premiums and, if not, what is the purpose of having less liquid positions in the portfolio. Some metrics to monitor in terms of portfolio liquidity include:
Two main factors that influence the ongoing portfolio monitoring process include major changes to the financial markets (external considerations) and internal considerations. If there have been major changes to the financial markets, how has the management team responded, and why? Internal considerations for the portfolio include any potential style drift or major changes in risk profile.
Investment management firms must operate as successful businesses, irrespective of their investment process or historical performance, to ensure long-term sustainability. Operational due diligence assesses a firm's integrity and risks by scrutinizing its policies and procedures. Key policies to examine include:
Important constituents of the framework are third-party service providers, including the firm's prime broker, administrator, auditor, and legal counsel. They provide an important independent verification of the firm's performance and reporting. These third-party service providers should be well respected and not subject to high levels of turnover and change within the management team.
The manager should have a risk manual that is readily available for review: Does the portfolio have any hard/soft investment guidelines? How are guidelines monitored? What is the procedure for curing breaches? Who is responsible for risk management? Is there an independent risk officer?
In order to ensure a long and prosperous tenure, an investment management firm must operate as a successful business. A manager that goes out of business does not have a repeatable investment process. An important aspect of manager selection is assessing the level of business risk. Allocators should be aware of:
Lastly, allocators should know about a firm's legal and compliance issues. Important issues include compensation arrangements for management. Whether employees invest their own money alongside clients. What is covered in the firm compliance manual? Whether the firm or any of its members has been involved in any investigations or lawsuits.
Question
Active investment strategies make assumptions about the dynamics and structures of the market, including all but which of the following:
- The correlation structure of the market is sufficiently stable to make diversification useful for risk management.
- Prices converge to intrinsic value, which can be estimated by using a discounted cash flow model.
- Market prices are driven by unpredictable macroeconomic trends.
Solution
The correct answer is C.
Answer choice C is incorrect. Active investment strategies do not assume that market prices are solely driven by unpredictable macroeconomic trends. Instead, they typically assume they can gain insights into market dynamics and trends that can be used to make better investment decisions.
A is incorrect. The answer choice is correct. Active investment strategies do generally assume that the correlation structure of the market is stable enough to make diversification useful for risk management. Diversification is a common technique in active strategies to reduce risk. When correlations are stable, diversification can help mitigate risks associated with individual assets or sectors.
B is incorrect. The answer choice is correct. This is another common assumption in active investment strategies. Active managers often believe that market prices will ultimately converge to their intrinsic value, and they use various valuation models, including discounted cash flow models, to estimate this intrinsic value. They seek to identify mispricing and make investment decisions based on these beliefs.
Reading 13: Investment Manager Selection
Los 13 (e) Evaluate a manager's investment philosophy and investment decision-making process