CFA L3 2020 - Study Session 15.3 (Reading 36): Investment Manager Selection

Investment Decision Making Process

1) Idea Generation 2) Idea Implementation 3) Portfolio Construction 4) Portfolio Monitoring

Performance-based Fees - Call Option

Bonus fee structures are analogous to: -> manager having a call option on the portfolio active return -> exercise price = base fee -> payoff = unlimited Net long position in call option on active return: -> would cause manager to take more risk because option pricing theory states that higher vol increases option value --> therefore, it's recommended that managers be both penalized for taking too much risk and rewarded for earning higher risk-adjusted returns

Capture Ratio - Evaluating Managers

Capture Ratios: determine how suitable a manager is with respect to the investor's risk tolerance and time horizon Reminder: Capture Ratio (CR) = UC Ratio / DC Ratio -> measure of return asymmetry CR > 1 = Positive asymmetry (convex) CR < 1 = Negative asymmetry (concave) When examining positive asymmetry -> question is weather strategy is naturally convex or if it occurs due to manager skill Naturally Convex Strategy - ex. hedging strategy where you buy a series of OTM puts prior to severe market downturn --> result = positive asymmetry w/ many small losses (low DC ratio) due to puts expiring worthless with way less large gains (high UC ratio) Manager Skill Strategy - ex. long-only equity strategy requiring active management to minimize losses and maximize gains --> requires manager skill but may not result in consistent positive asymmetry CRs can be used to confirm the investment strategy For ex: When betas are increasing (decreasing) -> momentum-driven strategy should have higher (lower) UC than value-driven strategy -> low beta (high beta) strategy will have lower (higher) UC and DC

Manager Contracts - Liquidity

Closed-ended funds and ETFs -> highest liquidity bc traded intra day Open-end funds -> almost as much liquidity but traded based on EOD NAV only LPs -> capital is usually locked up for more time PE and VC funds -> lowest liquidity due to capital calls SMAs -> liquidity depends on underlying assets Advantages of LP terms: - ability to have long investment horizon which prevents investors from overreacting to ST movements - allow for earning of illiquidity premiums - not forced to sell assets at depressed prices due to lockups, gates etc Disadvantages of LP terms: - difficult to change portfolio allocations in response to changes in the market - impaired ability to meet sudden liquidity demands

Costs of Type I and Type II Errors

Costs of Type 1 Errors: associated with retaining managers who are weak Costs of Type 1I Errors: associated with not retaining managers who are strong Assume two groups of managers (strong and weak) - greater differences in sample size and mean, the greater the costs of Type I and II errors - the wider the dispersion of returns between strong and weak, the easier to distinguish between relative skills and therefore makes it less likely to have a Type I or II error In an efficient market, dispersion of returns is probably smaller due to greater difficulty in achieving alpha through active management -> this would lessen the costs of hiring or retaining weak managers (i.e. Type I Error)

Drawdown - Evaluating Managers

Drawdowns are useful for identifying: - poor/poorly executed investment strategies - weak internal controls - operational problems Significant/extended drawdowns can cause: - manager to use self-preservation tactics that can harm investors Fine line between risk management vs self preservation: Question is: -> did the manager act properly in accordance with the IPS -> did the manager act for self-preservation reasons -> did the manager have a sudden overreaction In applying the concept of drawdown to the IPS -> investors with shorter time horizons and lower risk tolerance with less time to recover from losses should: --> invest with managers with smaller and less extensive drawdowns

Due Diligence

Due Diligence: analysis and investigation in support of an investment decision, action or recommendation -> must consist of manager universe, quantitative analysis and qualitative analysis

Evaluating Managers - Investment Philosophy

Entire investment process should be driven by a precise investment philosophy Managers who believe that markets are very efficient and that active management will underperform after considering costs -> manager will execute a passive strategy and attempt to earn risk premiums instead (i.e. equity risk, credit risk, liquidity risk, vol risk) Managers who believe markets are inefficient -> execute active strategy and exploit inefficiencies when prices differ from intrinsic value Investment Philosophy Must: - convey assumptions clearly and make sure they are consistent with the investment process - remain constant over time making it repeatable - if changes, are they because of market changes (this would support repeatability of process) or are they because of ST performance? - is the inefficiency being exploited more of an informational advantage or more of a structural inefficiency? Informational advantage: more ST in nature and less likely to be repeated Structural inefficiency: more LT in nature and likely more repeatable

Type I and Type II Errors

Hypothesis testing can be used when making decisions on whether to hire or fire a manager Null hypotheses (H0): there is no value added -> to demonstrate that there is value added on a statistically sufficient basis, calculated t-stat must be large enough so that null is rejected Type 1 Error: reject null when it's actually true (convict an innocent man; H0=innocent) -> null is rejected when there is actually no value added Type II Error: failing to reject a false null -> null is not rejected when in fact there was value added Type 1 Errors receive more attention than Type II because: a) Regret Aversion by decision maker which is linked to an error of commission (a type 1 error) -> Error of commissions (Type I): active decisions that result in explicit costs -> Error of Omission (Type II): result in less visible implicit or opportunity costs b) Type I errors are easier to determine (i.e. manager's relative performance can be measured vs a BM) -> Type II errors are difficult to determine (i.e. how do you objectively determine how a manager who was not hired would have performed?) c) Type 1 errors are more visible to clients who can easily determine that investments have underperformed the BM -> clients are less likely to follow or monitor managers who are not hired or who were fired to determine if managers would have added value over same time period

Manager Universe Stage

Manager Universe Stage - emphasis on manager's risk profile and whether or not it is a good fit for the portfolio's requirements - no performance assessment (this occurs during quant analysis) Universe consists of only those managers who: - are suitable for the portfolio in terms of objectives/constraints of the IPS - invest in the relevant style (i.e. value, growth, mixed) desired by the client - will manage the portfolio with the appropriate balance between active vs passive approaches Manager search - usually begins by establishing the role for the potential manager within the portfolio and that is defined by the benchmark

Three Basic Forms of Performance-based Fees

Performance-based Fees: form of risk sharing between investor and manager to align interests Three basic forms 1) Symmetrical structure with full upside and downside exposures -> provides greatest alignment between investor and manager incentives but increased risk to manager due to full downside exposure Fee = base + performance sharing 2) Bonus with full upside and limited downside exposures Fee = Greater of: (1) base, (2) base + sharing of positive performance 3) Bonus with limited upside and downside exposures Fee = Greater of: (1) base, (2) base + sharing of positive performance (within limit)

Performance-based Fees

Performance-based fee structures: transform symmetrical gross active return distributions into asymmetrical net active return distributions -> result is lower variance on upside vs downside --> therefore using a symmetrical risk measure such as standard deviation can lead to underestimation of downside risk! Benefit investors because: - investors will pay relatively lower performance fees vs fixed when there are low active returns Benefit managers because: - incentivize them to increase efforts to benefit investor's portfolio and increase their own comp

Qualitative Analysis Stage

Qualitative Analysis Stage Two important issues that arise: 1) Continuity of returns (i.e. What is the likelihood that the same level of returns will continue in the future?) 2) Risk assessment (i.e. Does the manager's investment process account for all the relevant risks?) 1. Continuity of Returns - can be assessed by looking at the four Ps: Philosophy - focuses on a specific area of market inefficiency to earn excess returns Process and People - determine whether strategy is feasible and if it's possible to execute the strategy with the given knowledge/skills of employees Portfolio - must be built in a way that's consistent with the philosophy and process 2. Risk assessment - considers the firm and whether it is robust and its likelihood of remaining a going concern - examine process and procedures of firm (i.e. quality of back office, ability to safeguard assets, and ability to prepare useful reports on a timely basis) -> operational DD! Must also consider: - Proposed investment vehicle: should be assessed for suitability within the portfolio - Terms of Manager Contract: must be reasonable and relevant in context of investment strategy and vehicle - Continual Monitoring is needed to ensure manager continues to be appropriate one for the portfolio

Quantitative Analysis Stage

Quantitative Analysis Stage: manager's performance should be evaluated objectively in terms of the distribution of past returns - use performance attribution and appraisal to distinguish between managerial skill vs luck - the Capture Ratio would examine performance in both good and weak market conditions - must check for any significant drawdowns

Pooled Investments vs SMAs - Costs/Benefits

SMAs - Provide Control: investor has direct and legal ownership of underlying securities which provides extra protection to investor in case of a liquidity event or bankruptcy of manager - Customization: allow for tailoring of client-specific objectives/constraints -> requires extra layer of DD - Tax Efficiency: higher in SMAs because only requires payment of realized cap gains - Transparency: provide instant snapshot of holdings at any given time - Higher tcosts: fixed costs are borne entirely by one investor; trading costs are also higher - Separate reporting Pooled Investments - Lack of control: investor is impacted by redemption demands of others - Taxes: may require payment of unrealized gains - Transparency: can provide snapshot of holdings but with a delay - Lower Costs: spread across multiple investors

Style Analysis

Style Analysis: examines the manager's risk exposures (i.e. industry, concentration, capitalization) in relation to an appropriate BM and the changes in those exposures over time - works best with publicly traded investments with frequent pricing data -> useful style analysis must be meaningful, accurate, consistent and timely Returns-based Style Analysis (RBSA): estimates the portfolio's sensitivities to security market indexes for a set of key risk factors - approach is top-down in nature -> risk factors are estimated rather than using predetermined style categories Pros: - analysis is relatively easy to compute - can determine key risk factors and return drivers for basic and complex strategies - use objective data and allows for comparability between managers and through time - can be performed on a timely basis Cons: - lacks precision bc it assumes that there is a static portfolio of the period - portfolio may contain illiquid securities so stale prices can understate risk exposure Holdings-based Style Analysis (HBSA): looks at the actual securities included in the portfolio at one time and allows estimation of current risk exposures using a more security-specific (bottom-up) approach -> most appropriate for equity-based strategies Cons - increase in computational requirement as complexity increases and transparency decreases - uses point in time analysis format that may not be useful if portfolio has high turnover

Investment Philosophy - Inefficiencies to exploit

Two Broad Types of Inefficiencies 1) Behavioral Inefficiencies: mispricings caused by other investors and their behavioral biases (i.e. trend-following) -> mispricings are very ST in nature and must be quickly exploited prior to market correction 2) Structural Inefficiencies: occur due to laws and regulations making them LT in nature If you have a valid inefficiency to exploit, there is a related issue of Capacity Capacity: the amount, repeatability and sustainability of the inefficiency -> ex. inefficiency must provide enough excess return to cover tcosts and fees Sustainability depends on: - market depth and liquidity - amount of capital that can be set aside to exploit inefficiency