Manager selection is an essential part of the day-to-day operation for asset allocators. Nonetheless, it is a relatively under-discussed topic in the industry. Institutional investors hire external asset managers to deliver alpha within each asset class they invest in. Finding truly competent managers can significantly drive the return of an investor’s portfolio.
Li Gao, former vice president of alternative investment manager selection at Goldman Sachs, recently wrote a white paper titled “Alternative Views on Manager Selection Best Practice", in which she lays out a few fresh insights on manager selection.
Traditionally, asset allocators select managers by evaluating them against a list of predefined qualities, a “box-checking” method that many firms consider comprehensive and systematic. However, managers who check all the boxes may still fail to deliver because “the investing industry is highly competitive and the majority of managers are more similar than dissimilar,” Gao wrote.
To address the challenge, she advocates for an holistic, “analytical” approach, which considers three seemingly unrelated aspects of investment: the manager’s comparative advantages over peers, the context within the total portfolio and applying the asset allocation philosophy to manager selection.
As an analogy, Gao compares manager selection with cooking a meal. “An asset allocator is somewhat like a chef, with managers as her ingredients. The best cook not only knows how to find the best ingredients (manager selection), but also know how to prepare them (portfolio construction). In addition, when certain ingredients are not available, the chef is able to create new recipes to ensure quality meals,” she wrote.
Below is the full version of the white paper:
About the author:
Li Gao is a seasoned asset allocator with 14 years of investment experience in both manager selection and direct investing. She most recently worked as the vice president of the alternative investment manager selection (AIMS) group at Goldman Sachs. Previously, Gao was a senior portfolio manager and the head of public equity at Shoreline Investment Management Company, a wholly-owned asset management subsidiary of Hewlett Packard (HP) that oversees more than $35 billion in assets for HP’s various retirement plans.
Prior to that, she worked with Rochdale Investment Management Company, an investment advisory firm, and Schultz Financial Group as a fund of hedge fund analyst. During her earlier career, she was an equity analyst at Haitong Securities (China) covering Chinese A shares.
Alternative Views on Manager Selection Best Practice
Three Essential Considerations
Asset allocators such as pension funds, foundations and endowments, and sovereign wealth funds usually hire external investment managers to make direct investments. The consensus view is for asset allocators to be responsible for asset allocation and external investment managers to deliver alpha within each asset class. In reality, however, due to the challenge of making tactical asset allocation decisions, most allocators actually spend more time on manager search in their day-to-day jobs. Interestingly, despite the importance of manager selection, very few studies have fully researched this topic. The industry also tends to underestimate the investment skills required in manager selection and can equate the process with thorough due diligence.
This paper argues that the manager selection process should go well beyond due diligence and emphasize the investment aspect. A box-checking mentality is harmful and can only produce mediocre managers. In addition, manager evaluation should always be considered in a portfolio context and share the same philosophy with asset allocation. A well-designed manager selection process should be result-oriented, dynamic, and innovative. An analytical framework is therefore introduced to discuss the three critical parts of manager selection process: manager selection, portfolio construction, and allocation philosophy.
Using a culinary analogy, an asset allocator is somewhat like a chef, with managers as her ingredients. The best cook not only knows how to find the best ingredients (manager selection), but also know how to prepare them (portfolio construction). In addition, when certain ingredients are not available, the chef is able to create new recipes to ensure quality meals. To illustrate the point, some traditional approaches are outlined for comparison purpose.
I. Consider competitive advantage: focus on selecting managers with competitive advantage in key areas
The traditional manager selection process tends to use a check-list approach that identifies certain factors (organization, people, process, performance, etc.) and sub factors that could influence investment results. Then allocators allocate scores to each factor based on managers’ strengths and weaknesses. This approach provides a systematic framework to guide due diligence and works particularly well in terms of identifying left tails. However, practitioners should avoid developing a box-checking mentality since the approach itself does not provide an effective roadmap to make hiring decisions.
A robust and systematic process does not guarantee favorable results. The selection and definition of factors can be arbitrary and not directly relevant to investing. When evaluating factors, practitioners often ignore one important fact: most of the factors tend to be necessary conditions rather than sufficient conditions and may not directly influence investment results. For example, most practitioners consider private companies with broad employee ownership a preferable organizational structure. However, many firms failed to generate alpha despite having the best incentives. Similarly, most allocators tend to believe adequate research resources are critical in terms of driving alpha. However, sometimes a large team could be a lot less efficient due to the logistics and challenge of collecting wisdom.
A manager could check all the boxes but still not deliver. If the approach is designed in a more granular way, it may have an additional disadvantage of mixing important and non-essential items. With hundreds of factors that require thorough investigation, practitioners could get lost in details and forget about the end goal.
Alternatively, an approach that focuses on competitive advantage helps prioritize efforts and emphasize key areas when conducting manager selection. Investing is a zero-sum game after fees, and only a small number of managers can consistently outperform. The best managers may have very clear edge in only one or two areas, but not necessarily score high everywhere. When identifying these edges, two things are critical. (1) Is the edge directly relevant to investment results? (2) Is the edge trivial or not? No two managers are exactly the same, and one can always be better than others somewhere. Always bear in mind that the investing industry is highly competitive and the majority of managers are more similar than dissimilar. Focusing on trivial advantages without having a high standard can only lead to mediocre managers.
Overall, a competitive advantage-focused approach offers at least two benefits. First, it helps to identify disruptive strategies, the right tails that are often overlooked during a robust due diligence process. Due to the wide availability of indices, selecting a mediocre “safe” manager makes less sense than selecting a star manager with some small risks. Second, because there is no easy way to define edge, the competitive advantage-focused approach helps train practitioners to constantly look for and re-define an edge. In this exercise, investors have to think from investing perspectives all the time and avoid developing a “box-checking” mentality. By comparison, religiously relying on a rigid predefined checklist approach may lead to obsession with the process itself instead of the more important results.
Below are five competitive advantages that can enhance managers’ investment results. It is hardly an exhaustive list. Given the innovations in the industry, there should be more edge yet to be discovered or defined.
Differentiated strategy. A differentiated strategy is probably the most important edge, among all others. Given the competitive nature of investing, crowded trades are the first thing to avoid. I would like to borrow an analogy Peter Thiel used in his book “From Zero to One” and apply it to investing. Tolstoy opens Anna Karenina by observing: “All happy families are alike; each unhappy family is unhappy in its own way.” In my observation, investment is the opposite. All mediocre managers are similar, but each good one is good in its own way. A differentiated strategy may be so powerful that even a mediocre PM or team could generate good investment results.
Under-researched markets or themes. Given the increasing transparency and information overflow in the industry, most markets are highly efficient, or at least more so than in the past. However, behavioral biases always exist, resulting in certain under-researched markets or themes. For example, Japan has been an overlooked market for many years due to very low coverage. Investors’ risk aversion often results in tremendous value opportunities in market sell-off, etc.
Talented people. In most markets, especially those efficient ones, the vast majority of investors have many years of experiences. If not combined with a differentiated strategy or under-researched theme, having experience only may not be sufficient to generate strong results. There is only one Warren Buffet. Allocators should maintain high standard when judging investors’ investment acumen. Knowledge and experience could be a commodity in an efficient market, and only very talented portfolio managers have an edge.
Proprietary technology. Some firms have built proprietary technology or databases that can significantly influence investment results. Renaissance Technologies founded by James Simons is a great example. The recent emergence of big data and artificial intelligence also enjoy some first-mover advantages. The construction of the RAFI index is simple, but its founder, Robert Arnott was smart enough to have patented the weighting methodology which kept away other competitors.
Low-cost pricing. Index funds (pioneered by Vanguard) and ETFs (pioneered by BGI) are probably the best examples of cost leaders in the industry. In recent years, certain new strategies such as Smart Beta and Risk Premia have also gained popularity. The commonality of these approaches is that they are mostly quantitative by nature and therefore easily scalable.
Admittedly, the obvious drawback of a competitive edge focused approach is that it does not provide quick-and-dirty rules how to identify an edge. Unfortunately, the art of investing often comes with no formula. Einstein’s combinatory play works as a great analogy for investing. In order to be successful in investing, the key skill is not to understand the facts or mechanically follow the rules, but to link information in unique ways and form sound judgment.
II. Consider portfolio context: develop a framework that emphasizes proper risk-taking
Evaluating a manager outside a portfolio context is like working in a vacuum. Most managers go through cycles and very few are “all weather.” It is unfair to directly compare performance by managers with different investment styles— each style performs differently in different market environments. To identify a manager’s edge is already a difficult task, and it becomes harder when it comes to portfolio construction.
At a very high level, there are two common approaches to construct a portfolio. The first focuses on selecting the best possible managers without predefined parameters, and then builds a portfolio by assigning different weights to each manager. The second approach seeks to build a risk-neutral framework beforehand and then look for managers that fit into each risk bucket. The challenge of the first approach is that there may not be enough interesting managers available, or those managers may move in the same direction without providing adequate diversification. The second approach emphasizes risk neutrality, but overemphasizing diversification could potentially leave additional alpha on the table. In addition, managers’ performance cannot always be explained by risk factors and strictly sticking to this approach may result in mismatch issues.
Regardless of the approaches, asset allocators are faced with the same question: what is the end goal of an optimal portfolio, and what is the best way to strike balance between risk and return? The key is to emphasize compensated risks (reliable alpha source) and separate out systematic risks (uncontrolled by managers). For example, a global equity portfolio is usually dominated by country risks instead of stock-specific risks. Therefore, one way to construct a portfolio is to select several country managers that can produce consistent alpha within each country and keep neutral country weight at the portfolio level relative to the benchmark. In this case, managers’ strengths (stock-picking capabilities) are adequately retained in the portfolio, whereas country risks (the uncompensated risks) are avoided.
Sometimes, it may not be possible to build a pure country-neutral portfolio due to certain challenges such as vehicle constraints, manager capacity and allocators’ avoidance of derivatives use etc. Under these circumstances, certain degrees of tilt at country or style level may be unavoidable. In my view, it is totally acceptable to have a pronounced tilt in a portfolio as long as risks are calculated and compensated. Risk management does not equal risk avoidance. A risk-neutral portfolio is not the end goal, but a portfolio with proper risk-taking is. In general, the probability of success in building a portfolio will be increased if the portfolio tilt meets all three criteria as outlined in the following diagram: managers’ strengths, alpha opportunities and asset allocators’ conviction.
For example, if a proposed international equity portfolio demonstrates heavy tilt to Japanese small cap stocks due to large allocation to a high-conviction manager, the asset allocator can evaluate the tilt based on the three criteria accordingly. (1) Does the tilt represent the manager’s strengths? If attribution models show that the manager consistently generates excess returns in the space regardless of market environments, the tilt may represent the manager’s peculiar skills and should not be hedged out or “diluted”; (2) Does the Japanese small cap market offer enough alpha opportunities? Studies have shown that the Japanese market is one of the most inefficient markets in the world due to very low research coverage as a result of two decades’ corporate deleveraging in Japan. In the meantime, the market is also very fragmental with ~70% of listed stocks concentrated in the small cap spectrum. The stickiness of alpha due to structural reasons can help smooth out the beta volatility associated with the Japanese small cap stocks; (3) How much conviction does the asset allocator have in the manager? If this manager is a high conviction manager relative to its peers, there is no need to deliberately bring down the allocation to this manager just for the sake of reducing the tilt to Japanese small cap stocks.
III. Consider allocation philosophy: define a philosophy that guides both manager selection and asset allocation
The traditional view holds that asset allocation and manager selection are two completely different tasks and should be handled separately. Asset allocators are in charge of asset allocation and managers are required to generate alpha within each asset class. In reality, these two tasks are actually closely linked with each other, which should be guided by a common investment philosophy.
Investing does not have a fixed formula, and different approaches could yield similar results. Asset allocators are in a unique position when approaching investing, and have many tools to enhance results: focus on asset allocation, hire the best alpha-generating managers, or blend these two. Regardless of the approaches, asset allocators have the flexibility to take an open, dynamic, and innovative approach, if supported by sufficient team resources. Here are several examples that could be implemented in both manager selection and asset allocation.
An open mindset. The fast-changing market environment requires a fresh set of eyes to reevaluate conventional ideas. The widely followed Yale model may not be the only way to approach asset allocation and certain risk-based approaches may justify a role. Similarly, the best equity managers may not necessarily follow the “style box”, and disruptive strategies are often hard to predefine. An open mindset to all investment approaches can provide more tools and increase probabilities to enhance risk-adjusted returns.
Forward-looking views. Mean reversion happens both at asset allocation and manager selection level, although not necessarily at the same time horizon. A good amount of studies show that mean-reversion typically occurs over multi-year time horizons which may coincide with allocators’ timeframe to evaluate managers. Not all asset allocators deliberately want to chase past returns, but it takes courage to overweight an underperforming asset class or hire managers that have recently underperformed. It is hard to completely avoid becoming a momentum investor investing at a mean-reverting entry point. However, allocators can at least adjust their views by incorporating some degrees of mean reversion assumptions.
Neither under nor over-diversify. Both under-diversification and over-diversification should be avoided in investing. Diversification should be measured by risk source, instead of the number of asset classes, managers or positions in a manager’s portfolio. The famous Yale model advocates investing in diverse assets, but unfortunately all those seemingly different assets are dominated by equity risks. Similarly, an equity portfolio may look diversified with many niche strategies invested in different stocks, but all the strategies could actually have the same risk driver. On the other hand, there is no need to be overly obsessed with diversification if low correlations come with stretched valuations in an asset class or low convictions in a manager. When blending managers in a portfolio, asset allocators have to decide how to balance conflicting considerations.
Decompose and repackage. Traditional asset allocation methodology uses equity, bonds, and alternatives to define asset classes. Newer thinking recommends either reclassifying alternatives under equity or fixed income or further decomposing returns into different Risk Premia Strategies regardless of asset classes. Similarly, equity managers’ returns can be decomposed and repackaged in order to emphasize “good” skills. For example, many bottom-up fundamental equity managers possess excellent stock-picking skills, but lack tremendously at sizing or timing. With the right attribution tools, allocators can identify true skills and weaknesses of managers and repackage them. For example, allocators can consider creating customized portfolios by forcing equal sizing or disciplined rebalancing rules. Reasonable use of derivatives can also help with either risk reduction (hedge out unintended risks or build a completion portfolio) or return enhancement (obtain exposure to an opportunistic theme).
Break silos. Due to the “narrow framing” bias, most investors tend to know parts better instead of the overall portfolio. From an asset allocation perspective, knowing how to aggregate information across asset classes and understand their interactions is a clear edge. Similarly, in terms of manager selection, allocators should also seek to break silos defined by styles and regions. Allocators don’t have to take a homogeneous approach when selecting managers within each asset class. Depending on market efficiency, fees, access, capacity, beta and alpha opportunities, allocators can hire different types of managers in each market. For example, a combination of specialist and unconstrained approaches may help capture managers’ strengths in both depth and breadth, and tactical shift between beta and alpha emphasis helps direct resources in different market environments.
Most industries are constantly looking for best practice for improvement. However, sometimes none are clearly defined. Investing is not science, and art cannot be quantified. In addition, if a certain approach has proved successful and becomes a standardized best practice, it becomes consensus, resulting in crowded trades. This paper is not meant to provide a guide to conducting manager selection due diligence by steps. Instead, it advocates an open, dynamic, and innovative approach and a willingness to take measured risks.
(Opinions in the paper are the author’s own and are not affiliated with any organizations.)