Assessing investment managers is a difficult task. Otherwise, why would asset owners devote so much time and resources, often with the help of consultants, to conducting manager searches? Proper selection and evaluation of managers requires extensive due diligence, but a relatively simple screen can serve as a useful initial screening of potential investment managers.
There are three fundamental questions asset owners should ask any quantitative manager before initiating their due diligence process with that manager. If a manager does not provide adequate answers, they may not be worth further consideration. Although we are focusing on quantitative managers, the same questions also arise for fundamental managers, particularly regarding the quantitative filters or signals they use in their investment processes.
1. What drives your investment process?
Investment managers should be able to explain the factors they consider most important to their investment decision-making and provide a conceptual rationale for them. For example, their equity factors should be economically intuitive and understandable rather than opaque or synthetic. As an example, consider the definition of the value factor. A single, understandable metric like price-to-book has advantages over hybrids, such as a “value” factor made up of a combination of price-to-book and price-to-earnings.
Why avoid such hybrid approaches? First, the evidence that the price-to-earnings ratio is a rewarding risk factor has much weaker empirical support than the price-to-book ratio. Second, even if we were to use both measures, a hybrid that combines the two individual measures in some way, say 50% price/book and 50% price/earnings, makes no economic sense. That is to say, of what is the return flow of the hybrid “factor” a return flow? Third, combining different measurements can give us exposures that we don’t want. Finally, even if we combine the factors as above, we will need to apply some form of weighting scheme, whether static or dynamic. But then we need to provide a rationale for our weighting system. If our only justification is that it worked well in a backtest, then we succumb to the most fundamental error in investing and statistics: we are basing what is supposed to be a generalizable investment strategy on an over-adjusted metric .
Thus, the use of a clear set of factors that makes economic sense and can be defended on conceptual grounds is essential in assessing whether a manager has a firm and well-constructed investment process or makes investment decisions based on on a set of more fragile considerations.
An additional important element of action factor strategies is to control the potential negative interaction effect between the various action factors. For example, stocks in a value strategy have at least some exposure to Momentum and Size, among other factors. If the exposure is large and negative, the strategy could eliminate the premiums reaped from the value exposure. Thus, managers must put in place a procedure that allows for factor tilts but controls for these negative interaction effects. Otherwise, a given strategy will stray from its stated mandate. Managers should be able to explain how their process ensures predicted exposures in the presence of interaction effects.
Finally, an important aspect of evaluating a manager’s responses to our first question is their consistency. What if different members of an investment team, for example the head of research and senior portfolio managers, have differing views on the most important factors in their investment process ? So maybe their strategy is not fully developed. This “inconsistency risk” can plague both quantitative and fundamental managers, but it is perhaps more prevalent among fundamental managers who often have less disciplined investment processes compared to their quantitative peers.
2. What evidence is there that your investment process will be effective?
A well-constructed investment process must be validated by a large body of empirical evidence and a full range of statistical tests. For example, a quantitative process must rely on very large data sets, tests using different subsamples, and various types of simulations. All of these validation methods should be documented, ideally in peer-reviewed journals. For example, Scientific Beta’s investment team has collectively published dozens of articles over the years that express its views and back up its approach to equity factor investing with evidence.
Why is it useful to publish articles in journals? Because it gives the entire investment community the opportunity to evaluate an investment team’s ideas. And because reviewers share no commercial interests with authors, their reviews are more objective. Publishing research helps establish the legitimacy of quantitative investment processes. Not only does it provide insight into a manager’s investment methodology, but it also aligns a manager’s research efforts with true scientific practice.
In science, answers to questions are derived from consensus. In other words, different research teams operating independently arrive at similar conclusions. Their results are therefore mutually reinforcing. If a manager cannot explain or provide support, empirical or otherwise, why their process works, asset owners should view this as a red flag.
Of course, some investment firms don’t publish their research because they say they want to protect the proprietary elements of their investment process, their “secret sauce.” But that’s not convincing. After all, other companies TO DO publish their research without fear of misuse. Either way, a company’s methodologies should be underpinned by both proprietary research on managers and research external to the company.
3. What risk controls are part of your investment process?
Ensuring that a strategy produces what it is intended to produce and does not expose itself to unwanted risks is an integral part of effective investment processes. For example, in an equity factor strategy, the goal is often to provide targeted exposure to one or more factors. Thus, the return of a value strategy should be driven primarily by exposure to the value factor. If a factor strategy’s return stream comes from other factors or from the idiosyncratic risk of individual stocks, unwanted risk exposures creep in. Thus, the lack of risk control can lead to unintended consequences.
Model misspecification is a potential risk in any investment strategy. Quantitative strategies, in particular, often determine the weighting of assets in their portfolio using some form of optimization. While any optimization may be limited, it could nevertheless unduly expose a portfolio to concentration risk in specific securities, regions or sectors, among other types of risk. After all, no model is perfect and each model processes input differently. As such, managers need to put controls in place to guard against a given pattern tipping the portfolio toward undesirable or overly concentrated exposures. Using multiple models to determine asset weights is one way to do this.
When applying a model, the selection of inputs to use is an important consideration. Does a process rely primarily on more stable measures, such as volatility, or on more erratic variables, such as expected returns? Managers need to provide this information to assure asset owners that their models are robust and stable.
Admittedly, these three questions are only the beginning of the due diligence process. However, as an initial filter, they are excellent starting points for evaluating any manager. If the answers to any of these questions are not satisfactory, the manager’s process may be fundamentally flawed and the manager may not be fit for further verification.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author(s). As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Alex Liew
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.