AgPa #60: Some Advice for Asset Manager Selection

Manager Selection, Deselection, and Termination (2020)
Mark Anson
The Journal of Portfolio Management Fund Manager Selection 2020, 46(5), 6-16, URL

After examining the end of the asset manager selection process (i.e. firing decisions) in the last post, this week’s AGNOSTIC Paper provides a broader overview. The author touches a lot of issues and provides some general advice how to cope with them in practice. As I mentioned, I am currently working on a manager selection process in my day-job and will therefore hijack a few posts to do my research.

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

Asset manager selection is an important discipline for many institutional investors because most of them simply don’t have the resources to do everything in-house. Manager selectors typically focus on active strategies, but many teams are also responsible for selecting passive instruments.1Comparing passive instruments is a rather mechanical task and focuses on issues like tax refunds, fees, etc. The author of this week’s paper, however, focuses almost exclusively on the more common part of selecting managers for active strategies.

At least for most public financial markets, empirical evidence clearly suggests that adding value with active investing is inherently difficult over the long-term and hard to distinguish from luck. Against this background, successful asset manager selection seems even harder. You need to overcome the odds against active investing in general and you must find a good manager to do it for you. You first search the talented needle in the haystack of managers. And subsequently, those search the profitable needle in the haystack of investments. From a pure statistical perspective, that doesn’t sound too attractive…

At this point, I should mention that this is my (current and maybe somewhat inexperienced) view on manager selection. I also had discussions with peers who argue that finding profitable investments is generally difficult but there is not necessarily a difference between securities and fund managers. Although I can understand the reasoning behind this view, I still believe that adding the manager-selection-layer makes things more complicated. But this is just a little philosophical side note and not the focus of this week’s paper. So let’s dive into the author’s advice for handling asset managers.

Data and Methodology

The paper is an overview about several issues in asset manager selection. Although the author uses some empirical examples, he mainly draws them from prior research and there is no specific methodology or data to discuss at this point.

Important Results and Takeaways

Asset owners seem to be bad in hiring and firing managers

The author starts with quoting a popular study on the results of more than 8,700 hiring decisions of asset owners.2Asset owners is the common term for institutional clients of asset managers. The results are not very promising. In the ten years from 1995 to 2004, the average fired manager outperformed the average hired manager over the following one, two, and even three years. Although these return differences are not statistically significant, the results indicate that asset owners don’t have the skill to add value from the timing of hiring and firing decisions. At least on average. Given the empirical evidence on active investing in general, this isn’t too surprising. It is just very difficult to time the market, no matter if you invest in securities or funds.

As I mentioned last week, the decision to fire an asset manager is an inevitable trade-off. On the one hand, you want to be patient enough and stomach temporary underperformance to secure the potential long-term outperformance. On the other hand, you must have the conviction that there actually is a long-term advantage and avoid sticking with a broken process for too long.

The author discusses this issue in context of the results above. He cites historical simulations and explains that frequent hiring and firing of asset managers is not a good strategy as it performed much worse than more forgiving approaches. He therefore concludes that asset owners should focus on patience to capture potential long-term outperformance. Interestingly, this is very much in-line with last week’s survey how asset owners actually approach the issue.

How to decide about firing a manager

The author recommends a systematic decision process to approach the trade-off around manager termination. Form my experience, this is very useful and I agree with him. There are many losing parts when it comes to evaluating asset managers and it’s hard to forget something or get biased in unstructured case-by-case decisions. In addition to that, there is a lot of evidence that checklists and protocols drastically improve outcomes in virtually all disciplines.

The paper includes an example for a decision process without going into too much detail. Specifically, the author distinguishes dark and light flags. Dark flags capture critically important points that can lead to an immediate termination of the manager. Examples are Regulatory Concerns (you don’t want someone who breaks the law), Strategy Shifts (an equity manager who suddenly invests in other asset classes), and Key Person Issues (your fund manager disappears for whatever reason).

Light flags capture the usual points like Performance, Investment Process, Team Structure, the Strategy, and Strategy Drift. As for security analysis, there is not the one formula to evaluate fund managers and its part of the selector’s job to come up with a process that works. But as you know, I am a fan of systematizing things for better outcomes. Therefore, I find it quite useful to go through a checklist when dealing with an underperforming manager and the paper provides a helpful place to start.

In practice, larger reviews and analyses will most likely begin after a period of underperformance. In a perfect world, you would then just go through your protocol and check if there are real problems or if the underperformance comes from inevitable noise of financial markets. The author gives the example of underperforming value managers who had a very hard time during the last 10+ years. Value strategies suffered from a painful drawdown and if you are a pure value-manager it is hard to escape from that. As strange as it may sound, a value manager losing 40% when her benchmark loses 50% still does an outstanding job even though the end-result is of course disappointing.

Style Drift, Style Clustering, and Fees

One of the largest issues, and I can confirm that even from my short and limited experience, is Style or Strategy Drift. Being an asset manager is a though life because you can do everything right and still go under because of the random element in financial markets.3Of course, this tough life is often very well compensated. So no need for pity… Being a value manager and living though 10+ years of underperformance is challenging, and even more so when you and your family make a living from this job. As a consequence, many managers throw the towel at some point and deviate from their original strategy. In most cases, they (unsurprisingly) add something that recently worked very well.4Some value managers, for example, began to define their style more broadly and also invested in stocks that look more expensive on traditional measures.

Many investors consider such style drifts as negative signs because it could indicate that the manager cares more about short-term results and popularity than sticking to her long-term process. Of course, there is a again a trade-off between stopping things that no longer work (which is absolutely necessary!) and blindly following the thing that is currently en vogue. Once again, there is not one single formula to evaluate such situations and handling style drift is one of the major practical challenges for manager selectors.

Interestingly, the author also explains that the opposite, Style Clustering, also happens. The rapid development of factor investing made the asset management industry much more specialized. For example, most institutional investors no longer just allocate capital to one manager for US Equities but also decide whether to invest in US Small Caps, Value, Quality, Momentum, you name it. That shifts a lot of the overall performance responsibility back to the asset owner. Just remember the example of the value manager who loses 40% against a benchmark loss of 50%. The performance is of course shitty but the manager still did a good job. The problem was the allocation to value.

Finally, the author also briefly touches the very important issue of fees. Empirical evidence shows that the average manager charges too much for her services but this is actually not the primary focus here. Instead, the author shows at the example of hedge funds that most managers cluster themselves into very similar fee structures. In fact, many fund managers seem to simply adapt well-known and somehow accepted fee structures like “2 and 20”. Given the large differences across investment processes and manager skill, a rather standardized price doesn’t make sense. The author therefore advises investors to always check if the fees are consistent with the potential alpha opportunity or if the manager is just trying to lock-in some well-known fee structure for a non-sophisticated product.

The very important difference between Alpha and Beta

Very much related to the previous point about fees and a never-ending issue within the industry is the difference between Alpha and Beta. The details are beyond the scope of this post, so let me give to the most important points. Beta is the return you get from just being exposed to a well-known risk factor. For example, most of us believe that the overall stock market will deliver a positive return over the long-run. You just need to buy a passive index fund and wait. You don’t need special insights or compete with other investors, therefore it is Beta. Alpha captures all returns beyond such a passive benchmarks. To generate Alpha, you need a competitive advantage over other investors which is difficult and costly. Alpha is therefore limited and expensive while Beta is cheap and available for large amounts of capital.5Factor investing provides some middle-ground between Alpha and Beta. But as I mentioned, a full discussion is beyond the scope of this article…

Going for Alpha or searching a manager who does it for you is difficult, but there is nothing wrong with trying to do it. What is wrong, however, is to pay Alpha fees for a Beta investment process. You don’t need to pay a large fee for the performance of the overall stock market because Vanguard and BlackRock deliver it for a few basis points. Unfortunately, the author explains that many active manager are so called Hidden Index Providers.

Hidden Index Providers are too close to their benchmarks to earn Alpha but charge fees as if they would do it. Needless to say, investors must therefore carefully consider whether their manager really has a unique process or if it is just clever marketing. I mean, no one would go to McDonalds and pay the price of a Michelin restaurant. So why do that with asset managers? And if you are not sure if it is Alpha or Beta, it is probably Beta…

Momentum and Crowding

Momentum is a very well-researched phenomenon in many fields. One that is particularly relevant for asset manager selection is Crowding. A Crowded Trade refers to a situation where many different managers hold identical or very similar positions. That can be the result of Beta-like investment processes (see above) or a consequence of managers blindly following trades that are currently popular (see above above). No matter the reason, crowding is a potential problem because it erodes diversification benefits in a multi-manager portfolio. You don’t need two different managers to invest in the same positions. The author therefore advises investors to evaluate managers not on a stand-alone basis but in context of the total portfolio.6It is generally a good idea to evaluate positions in light of the total portfolio, not only for asset manager selection…

Conclusions and Further Ideas

The author touches a lot of important issues in manager selection and this post became longer than I originally planned. From my perspective, however, it makes sense to cover all of them because they frequently arise in practice. The article is of course just an overview and doesn’t go into much detail how to analyze each of the issues. That is not too surprising because establishing such analyses and processes is the real work in asset manager selection. And very similar to the details behind investment processes for securities, people are not willing to share details of a profitable process. This is totally understandable and fine. Nonetheless, the author provides a helpful blueprint and I think it makes sense to approach manager selection (as all other investments) in a systematic and disciplined way.

What I think is missing from the overview is the human part of manager selection. In the end, asset managers are human beings and even if you go with quantitative strategies you need trustworthy people. There is a lot of research examining how certain personality traits correlate with success in asset management and I think investors should definitely consider them when selecting managers. Next week, we will have a quite funny introduction to this topic.

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1 Comparing passive instruments is a rather mechanical task and focuses on issues like tax refunds, fees, etc.
2 Asset owners is the common term for institutional clients of asset managers.
3 Of course, this tough life is often very well compensated. So no need for pity…
4 Some value managers, for example, began to define their style more broadly and also invested in stocks that look more expensive on traditional measures.
5 Factor investing provides some middle-ground between Alpha and Beta. But as I mentioned, a full discussion is beyond the scope of this article…
6 It is generally a good idea to evaluate positions in light of the total portfolio, not only for asset manager selection…