Screening on a fund manager database is the first step in the manager-selection process, enabling investors and consultants to narrow down a large universe of strategies, eVestment, the big database provider, suggests.
But Stephen White, eVestment’s marketing manager for the EMEA region, says that there is no single ‘bullet-proof’ or ‘one-size-fits-all’ approach to manager selection. He says that, if screening is done too hastily, it can create bias and limit an investor’s investment options.
“We’ve outlined some key approaches the we have observed that the most successful investors and consultants take to help [clients] think about their own processes,” he says. These include:
1. Define the objective of your manager search
This may be stating the obvious, but it is crucial to define the objective of your manager selection process. What types of managers are you looking for?
For example, one portfolio manager at a large Danish pension fund told us recently that she looks for two things. First, because things always change, she wants to find a captain, a crew, and ship that can navigate through the changing environment. Second, she focuses on finding managers that have a high probability of coming out on top in the long run.
There is no ‘one truth’, however – you need to define your own objectives for manager selection.
2. Cast the widest net, quickly
Once you know what you are looking for, it is essential you appraise the full universe of managers that have strategies meeting your investment goals. That is naturally where an investment manager database helps as you can research the full breadth of a universe.
For example, the eVestment emerging market equity universe contains over 600 institutional strategies, and over 1,400 investment vehicles. Obviously, you would need to narrow this list down to effectively analyse strategies of interest.
You also want the process to be efficient and cost-effective as you don’t want to spend several weeks or months collecting data, analysing and comparing in Excel. That is not a good use of your time.
3. Don’t screen on performance first
Many investment processes start with screening on performance and risk metrics, such as three-year return or standard deviation. However, we all know the industry disclaimer: “past performance is not a guarantee of future results” – so why use track record as the main screening factor?
For example, in the emerging market equity universe in the eVestment database, of the top quartile performers three years ago, just 36 per cent remain in the top quartile today. Put another way, if you had only looked at top quartile managers three years ago, you would have missed out on 64 per cent of today’s top performing managers. The mean reversion embedded in managers’ performance will lead you to retain many managers that will underperform, and you are essentially introducing a bias early on in your manager selection process.
This is not to say that analysing returns isn’t important. It is. But it should not be the first or only screening criteria.
4. Screen on characteristics
Instead of focusing on performance, we see many clients start with defining the characteristics of the managers they are looking for.
We outlined an extensive list of characteristics investors might consider in our recent webinar, ‘Screening for Success’. For example, is your ideal manager independent thinking? Is there stability in the team? Is it a stable and supportive organization? Does the manager exhibit true alpha? Is the strategy cost-effective from a fee perspective?
Once you have defined the characteristics you are looking for, you can pick metrics or data points to evaluate them. For instance, a proxy for an ‘established team’ could be done by screening for strategies where the average experience of a portfolio manager at the firm is greater than 10 years. The ‘stability’ would be highlighted when the team has not experienced turnover. The ‘level of conviction’ can be illustrated with a relatively low number of holdings, high active share, or with a fully invested portfolio. These are just a few examples out of the thousands of data points that eVestment captures.
5. Order matters
The outcome of your investment process will change depending on the order in which you apply the criteria.
Using thresholds early on can create unintended consequences, and you may want to observe the universe and adopt a trial and error approach to find the best balance. This is in our experience the best approach to create a shortlist of managers with the highest chance of a successful outcome.”
Stephen White says: “At eVestment, we believe taking a more holistic and integrated approach from the beginning of the screening process leads to the best outcomes. You want to find managers with the highest probability of generating the best future returns, so applying too limited a focus on past returns can be counter-productive. If done well, screening can provide a strong list of potentially winning managers to further consider as part of your investment due diligence process.”
Greg Bright is publisher of Investor Strategy News (Australia)