The Manager’s Investment Philosophy

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.

Investment Philosophy

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:

• Equity risk.
• Duration risk.
• Credit risk.

These strategies can also look to capture alternative risk premiums including:

• Liquidity risk.
• Natural disaster risk.
• Volatility risk.

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.

1. Structural Inefficiency: These arise from rules and regulations, causing perceived mispricing. They can persist as long as the rules remain independent of market players.
2. Behavioral Inefficiency: These result from market participants’ biases, like trend following or loss aversion, creating mispricing. These inefficiencies are temporary and allow managers to exploit them before market prices align with perceived intrinsic value.

Active strategies rely on assumptions about market dynamics and structures, including:

• The correlation structure of the market is sufficiently stable over the investment horizon to make diversification useful for risk management.
• Prices eventually converge to intrinsic value, which can be estimated by using a discounted cash flow model.
• Market prices are driven by predictable macroeconomic trends.

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.

1. Clarity of Investment Philosophy: Can the manager clearly and consistently explain their investment philosophy? This clarity lends credibility to the process and checks whether the strategy aligns with the stated philosophy.
2. Credibility and Consistency of Assumptions: Do the assumptions resonate with the decision maker, and are they in harmony with the investment process? For instance, an active manager should believe in some level of market inefficiency.
3. Philosophy Evolution: How has the investment philosophy evolved over time? Ideally, it remains consistent, signaling a repeatable process. Any changes should have sound reasons; otherwise, they may suggest a lack of repeatability.
4. Linking Return Sources to Inefficiencies: Are the sources of returns connected to credible and consistent market inefficiencies? Decision-makers must determine whether the philosophy is based on an informational advantage (typically behavioral inefficiency) or a structural inefficiency, indicating process repeatability.
5. Capacity Considerations: Even after confirming a credible and repeatable process, capacity becomes a concern. Capacity relates to the level, repeatability, and sustainability of future returns supported by the identified inefficiency.

Investment Personnel

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 team size given the strategy.
• Key person risk.
• Management agreements.
• Personnel turnover.

Investment management agreements will be covered in further detail in another section summary.

Investment Decision-making Process

The investment decision-making process is comprised of four elements: signal creation, signal capture, portfolio construction, and portfolio monitoring.

Signal Creation

Signal creation is the foundation of trade decisions, and it should possess three key qualities:

• Uniqueness: A manager using the same signals and data as others risks losing their informational edge. Questions to consider include: What data is collected? How is it used? What distinguishes this process from others with similar mandates?
• Timeliness: Does the manager excel in discovering and leveraging information faster than competitors? If so, what tools and procedures grant this advantage?
• Unique Interpretation: How the information is utilized matters. How does the manager perceive the gathered information? It's important to assess whether the manager is transparent about their interpretation process or claims to have a secret advantage or superior intelligence compared to the market.

Signal Capture

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.

Portfolio Construction

This phase delves into risk management. Allocators seek insights into how the portfolio is assembled and whether positions complement each other, capturing diversification benefits.

• How are portfolio allocations set and adjusted? The allocation process should be well-defined and consistent, supporting the repeatability of the investment process. For example, are allocations made quantitatively or qualitatively?
• Do the positions the manager believes will most likely outperform or exhibit the greatest outperformance receive the largest active overweighting, and vice versa?
• How have the portfolio characteristics changed with asset growth? Has the number and/or characteristics of the positions held changed to accommodate a larger amount of AUM?
• Does the portfolio use stop-losses to manage risk? What types of stop-losses are used? Although stop-losses represent a clear risk management approach, the goal of protecting against large losses must be balanced with the risk of closing positions too frequently.
• What types of securities are used? The manager should be well-versed and experienced with the securities used to understand how they will behave in different market environments.
• How are hedges implemented? What security types are used? How are hedge ratios set?
• How are long and short ideas expressed? Are they paired—that is, each long position has a corresponding short position—or are long and short positions established independently?

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:

• The amount of time it would take to liquidate 5% and 10% of a portfolio.
• The average daily volume-weighted by portfolio position size.
• Any portfolio securities that have had trading restrictions, and if so, why?
• Holdings in the portfolio that account for a large percentage of total market cap, such as more than 5%.
• Does the manager provide liquidity to the market or use it?

Portfolio Monitoring

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.

Operational Due Diligence

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:

• Trading policies.
• Soft dollar commissions.
• Safeguards against unauthorized trading.
• Investment fee calculations.
• Pooled vehicle vs. separately managed accounts.
• Firm infrastructure and technology.
• Any offsite tools and facilities used.
• Cyber security measures used.
• Number of strategies used and contemplated.

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.

Risk Management

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?

Firm

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:

• Ownership structure of the firm.
• Total firm AUM and AUM by investment strategy.
• The firm's breakeven AUM.
• The amount of capital the firm would like to raise.

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:

1. The correlation structure of the market is sufficiently stable to make diversification useful for risk management.
2. Prices converge to intrinsic value, which can be estimated by using a discounted cash flow model.
3. 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.

Performance Measurement: Learning Module 2: Investment Manager Selection; Los 2(e) Evaluate a manager's investment philosophy and investment decision-making process