Key Factors to Consider When Selecting an Investment Manager

There are many factors to consider when selecting the right asset manager; however, two of the most important relate to its track record and benchmark selection.

The Process of Selecting a Manager

How do you choose an asset manager? First, it is of critical importance that investors determine an investment objective that includes expected returns and an acceptable amount of risk. Communication and transparency are vital when analyzing managers and all parties need to set realistic goals about what they hope to achieve within their investment mandate.

Once an objective has been set, the next priority is to look for long-term managers that can demonstrate a history of outperformance over the public market based primarily on two weightings: time-weighted, which is a measure of the compound rate of growth in a portfolio, and dollar-weighted, which is equivalent to the internal rate of return (IRR). A manager’s long-term track record is one of the only ways to evaluate its performance; so before making a commitment, investors need to understand what constitutes an appropriate track record.

It is also advisable to look at a manager’s track record through multiple economic cycles and across multiple funds. A market cycle is typically three to five years and it is dangerous to analyze a manager over that relatively short time period without understanding what its investment philosophy is, and how it has performed over the past six to eight years compared to its peers benchmarked against similar markets. No track record is a clear strike against the manager and, ideally, the manager will have more than five years’ worth of performance to compare.

In addition, the more volatility that occurs during market cycles, the easier it is to truly understand how a portfolio is being managed and where a manager has outperformed and underperformed. Although many active managers have underperformed over the last three to five years; however, we’re not seeing a lot of trustees terminating managers because they have an understanding about the philosophy and process in the context of these evolving markets. This is a testament to trustees’ understanding of the risks involved in investing and trusting that their managers are following their mandate to the best of their ability.

Public funds operate in a fish bowl. There is tremendous pressure when they are analyzing managers and public fund boards have significantly improved their ability to examine the philosophy of the manager and not solely look at performance. Furthermore, they must ensure board members are not just buying big brand name firms. Instead, they should be turning to smaller shops that have been successful in raising assets, regardless of brand.

Selecting the Appropriate Benchmark

Once manager due diligence has been completed and the investment objective has been agreed upon, the next step for the manager is to select a benchmark to help effectively assess the success of its performance. This is often one of the last components considered in the pension management process and is often the most overlooked.

Typically, investment managers will select the benchmark against which prospective investors will evaluate their performance. While investment managers must conform to rigorous criteria for investment performance reporting, they generally are free to choose any benchmark against which they can compare their performance when marketing to prospective clients.

As a consequence, investors often struggle to determine whether the manager has chosen an appropriate benchmark. The question is often asked: Should managers select an “easy-to-outperform” benchmark that makes their performance appear successful? Or should they select a benchmark that provides the potential for better investment returns for their clients–even though it may be more challenging to demonstrate success? For the vast majority, the answer to this question should be obvious.

A solid institutional asset manager will select benchmarks that most closely match its investment strategy for a particular asset class and accurately measure the breadth of securities held in a portfolio, even if the chosen benchmark may be more difficult to outperform.

Good benchmarks should reflect the strategy and style of the investor’s portfolio, taking into account acceptable risk and the desired return. The benchmark selection process should match the agreed upon investment philosophy for a particular asset class with the range of securities held in the fund. In the investment management industry, relevant performance benchmarks should have the following characteristics:

• Be understandable and eliminate any confusion as to what is held in the benchmark;
• Include investable and liquid securities; and
• Be clearly defined and easy to identify, with a construction methodology, weights and names of securities comprising the benchmark.

Also, the performance of the assets held in the benchmark should be priced regularly and historical data should be widely and economically available and accessible. In addition, changes to the benchmark constituents should be reasonably low to reduce turnover and keep trading costs down.

While there are thousands of benchmarks to choose from, in some cases it may make sense for a manager to create a custom benchmark. For example, if the manager cannot find a standard benchmark to represent the investment set, two or more benchmarks that would include a broader investable universe can be combined. Put simply, the most important consideration for investment managers is to find a standard or customized benchmark that accurately and objectively represents its strategic investment goals.

Here are the top 10 questions investors and their consultants should ask managers:

• Why is your current benchmark an appropriate performance measure for your fund’s exposure/style?
• What other benchmark options may be available in the marketplace that would be appropriate for your fund?
• What is the cost associated with your various benchmark options? (Ensure that you receive a breakdown of fees)
• Why have you opted to use your current benchmark provider to measure that exposure?
• If selecting a more expensive benchmark, what is the value-add you are receiving for it?
• Is there an opportunity to lower your fee by requesting use of a more cost-efficient benchmark?
• For your chosen exposure, which benchmarks are the most efficient to track from a trading standpoint and why?
• What are the resulting differences in transaction costs? (Spread?)
• What is your ability to hedge your exposure to this benchmark through tradable products?
• What are the cost implications to your custodian for reporting on this benchmark?

Keep in mind, when choosing a manager you have to trust the people you are working with because you are entering into what should be a longstanding partnership. Due diligence is incredibly important to ensure that you have the right manager, benchmarked to the right index, to help make decisions that will hopefully optimize your investment returns and position your portfolio for long-term success. 

John Jacobs, executive vice president and head of the Global Index Group, NASDAQ OMX