Whether it involves skill, good judgment or just plain luck, choosing the right manager is never an exact science but recently published research reveals institutional investors can make better decisions by avoiding conventional wisdom around past performance.
Research conducted by consultants Russell Investments and Wurts & Associates has looked at the question of how to select managers and found that a selection process based on analysing past performance does not improve the chances of achieving alpha in the future.
While many investment decisions are essentially analytical decisions, Russell Investments’ chief research strategist, Bob Collie, and co-chair of global consulting, Don Ezra, say that manager selection is much more nuanced than just crunching the numbers.
“Because of limited information and dynamic conditions, manager selection should not be regarded as a quantitative, rules-based process. Manager selection is a skill, like many other skills,” they write in their report “Resist the Amygdala! Improving institutional investment decision making”.
“Like most skills, it comes down to a mixture of natural aptitude, training and experience. Rigorous analysis can inform and support the process, but not replace it.”
Wurts & Associates director of research Eric Petroff is more blunt, saying investors ignoring what he describes as the obvious facts about using past returns to predict future performance are “nutso”.
Petroff says that their research, which looks at active management returns over time, shows that over long periods excess returns could not be sustained.
One such example focused on a core plus fixed and US small core only strategies. It found achieving consistently top quartile results was a “very low probability event”. Only 2 per cent of strategies consistently stayed in the top quartile for rolling five-year excess returns over a decade.
“So being surprised by peer ranking drift for an active manager is like being surprised when the sun rises every morning,’ Petroff says in the Active Management Environment report.
“The conventional wisdom of holding managers to task on peer ranking fluctuations is just not a productive pursuit.”
If, therefore, the chances of choosing a successful manager are not in investors’ favour, Petroff says they should instead either focus on the need to actively manage allocations amongst managers or between active and passive strategies as well.
Collie and Ezra in their report titled, “Resist the Amygdala! Improving institutional investment decision making”, say that, despite it being a predictable occurrence that managers will underperform, many investors are not adequately prepared for just such an eventuality.
“Unfortunately, we do not generally know when a manager will hit a tough spell, but we know it will come eventually,” they say.
One of the difficulties the report identifies is the lack of information available for investors when choosing a manager.
While acknowledging analytical information about managers was bountiful it was of limited use and could not form the overriding basis of a selection decision, Collie and Ezra found.
“Information on managers abounds but it is largely irrelevant, constantly changing and often misleading,” they write in the report.
“It is this lack of relevant information that makes manager selection and monitoring so difficult.”
Rather than following set-in-stone analytical procedures and rules, Collie and Ezra say experienced individuals using their judgement should be given weight in the selection process.
Investors should not aim for the perfect decision and instead should look for a good decision, and look for ways to build in methodologies to improve decision making skills.
Collie and Ezra cite the work of a psychologist, Gary Klein, who specialises in naturalistic decision making which studies how people actually make decisions and perform complex cognitive processes in challenging environments.
Klein makes four key observations about how experts learn and develop their skills:
• They engage in deliberate practice, so that each opportunity for practice has a goal and evaluation criteria.
• They compile an extensive experience bank.
• They obtain feedback that is accurate, diagnostic, and reasonably timely.
• They enrich their experiences by reviewing prior experiences to derive new insights and lessons from mistakes.
A recent report: “Lost in Transition? Factoring in Costs Before Switching Manager” by Mercer Investment Consulting also looks at changing managers and the costs the transition entails.
The report’s author David Scobie, a principal in Mercer’s New Zealand operation, says a badly handled transition can leave investors with loses of between 2 and 3 per cent of the total value of the portfolio.
Even if a sophisticated transition process is undertaken, Scobie says no process is costless with both direct or visible cost and non-visible or implicit costs.
Direct or visible costs are such things as the bid/offer spreads a fund will face when exiting a particular equity position; brokers’ dealing commissions; taxes and any fees paid to a transition manager.
The indirect costs, while less obvious, are likely to exceed these direct costs, Scobie says.
They include the market impact of exiting a particular position, particularly when it comes to stocks in small, less liquid companies.
A manager who looks to avoid market impact may also incur an opportunity cost if prices fluctuate when attempting to either delay trading or sell smaller parcels of stocks.
There may also be out-of-market costs where exposures to a particular asset class cannot be fully maintained due to a lag between selling out of one position and finding another suitable, well-priced opportunity.
Finally there is operational risk associated with the transition where the relatively unusual activity of changing a manager heightens the risk of a failure in internal processes, people or systems.
Scobie advises using a transitional manager to manage these different indirect and direct risks when two of the following four factors are present.
- The total transaction volume is more than $50 million.
- The transition is not expected to be straightforward either through complexity or a lack of internal resources.
- Out-of-market risks are elevated due to a material portion of the transfer not expected to occur in specie (for example 10 per cent).
- Tolerance for out-of-market risk is low.
Investors should also consider that if a transition manager is not used the default is typically that the terminated manager handles the transition. Often there is not a strong alignment of interests between the investor and the manager handling this process. Likewise, if the transition is handled by the new manager, “performance holidays” are typically negotiated during this period.
