Reading 36: Investment Manager Selection Flashcards
Holdings Based Style Analysis (HBSA) & Returns Based Style Analysis (RBSA)
RBSA requires less effort acquiring data than HBSA. HBSA requires data on each security and is a snap shot at a certain point in time, which could cause window dressing. Both HBSA and RBSA are subject to difficulties when interpreting illiquid assets. RBSA is comparable across managers and through time. HBSA is bottom up, where as RBSA is top down (returns sensitivities to security market indexes).
Inefficient Assets
Exploiting pricing inefficiencies is repeatable if the aggregate value the mis priced asset is larger than the AUM of the manager and its competitors.
Forming Manager Universe
Build a universe of managers that could satisfy portfolio needs, do not focus on historical performance, identify a benchmark to define manager’s role, third party categorisation can be used to build the initial universe which is then further refined.
Volatility of Net Returns
Incentive fees are calculated as a percentage of returns (reducing net gains or losses) and therefore lowers standard deviation of realised returns. Management fees are charges on AUM, which lowers the realised return but does not effect standard deviation of returns.
Symmetrical Fee Structure
Where the fees are affected by both positive and negative performance.
Fee Structures
The performance can be net of the base fee, where you would subtract base fee of return. Or performance could be based on active return only, so you would subtract the benchmark.
Quantitative Analysis
Manager evaluate objectively based on distribution of past returns. Includes performance attribution and appraisal, the capture ratio, significant drawdowns.
Qualitative Analysis
Looking at continuity of returns. Philosophy (market inefficiencies), process, people, portfolio aligned with philosophy. Quality of back office, operational due diligence, investment vehicle suitability.
Type 1 & 2 Errors
Null is that manager has no skill. Type 1 is reacting a true null (keeping underperforming manager hired), type 2 is accepting a false null (not hiring or firing a skilled manager). Type 1 is error of commission that result in explicit (visible) costs. Type 2 is error of omission and result in opportunity costs (less visible). Wider dispersion of returns between strong and weak equals lower type 1 and 2 errors. Efficient markets equals lower cost of type 1 error (as active management returns are low). Mean reversion occurs that increases errors of type 1 & 2 if fired to fast or held to long respectively.
Style Analysis
Relevant when comparisons can be made over time and between managers on a timely basis when risks analysed are the key sources of risk and return. Works best for publicly traded securities with frequent pricing. Style analysis can still be used for illiquid investments.
Investment Philosophy
If managers thinks markets are efficient, they will invest passively and gain returns through risk premiums from systematic risk exposures (equity, credit, liquidity, volatility). Active managers will look for inefficiencies that can be behavioural (trend following, are short term and must be executed very quickly) or structural (laws and regulations, more long term in nature).
Investment Decision Making Process
Idea generation: investment signals used to establish positions to exploit inefficiencies. Idea implementation: the idea is transformed into a position, called signal capture (think repeatability and alignment with philosophy). Portfolio construction: what type of securities to use, stop losses can be used. Hard stop loss could cause premature closing of position, soft stop loss has an evaluation before selling.
Separately Managed Accounts
More costly (as single investor bears all fees and trading costs cannot be aggregated) but more customised than pooled investments. Investors has ownership of all assets (as there is only one investor). Provide greater transparency. Investor is not effected by redemption like in pooled investments, only payments on realised capital gains (not unrealised like pooled investments).
Liquidity
Closed ended funds and ETFs have the most liquidity as they are traded intra day. Open ended follow closely as they are traded on end of day NAV. Limited partnerships, private equity (returns after 5 years typically), hedge funds are all illiquid.
Basic Forms of Performance Based Fees
Base plus performance sharing is symmetrical and greatest alignment with investors but manager is exposed to full downside. Higher of base or base plus sharing of positive performance. Higher of base or base plus sharing of positive performance with a limit. Similar to having a long position in a call option on portfolios active return, with exercise price as the base fee. A long call (exercise base fee) and a short in a less valuable call with exercise price equal to maximum fee caps the fee and disincentives the manager from taking on too much risk to get returns.
