Investment Manager Selection

Choosing a manager means judging whether past results reflect skill that will persist, whether the firm can be trusted with assets, and whether the vehicle and fees serve the client. This module covers the selection and due diligence process, Type I and Type II errors in hiring and firing, style analysis, capture ratios and drawdowns, the evaluation of philosophy, process and team behaviour, the choice between pooled funds and separate accounts, and the design of performance-based fees.

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What you will learn

1. Outline a manager selection and due diligence process, and explain Type I and Type II errors in hiring and firing managers.

Process: define the need, screen, investment due diligence, operational due diligence, negotiate terms, monitor.
Null hypothesis: the manager has no skill. Type I = hiring or keeping an unskilled manager; Type II = rejecting or firing a skilled one.
Stricter screens reduce Type I errors but increase Type II errors.
Short records cannot separate skill from luck because return distributions overlap.
Type II errors are hidden opportunity costs, so committees tend to fire too quickly.
Operational failures (custody, valuation, auditor) can cause losses that no investment skill offsets.

2. Use returns-based and holdings-based style analysis, capture ratios and drawdowns to assess a manager's record.

RBSA is a constrained regression; its weights are the effective style mix.
Selection return = manager return minus the style benchmark return, including any cash weight.
R-squared is the share of return variation explained by style; rolling windows reveal style drift.
Holdings-based analysis is precise at a point in time but depends on timely, honest holdings data.
High upside and high downside capture together signal high beta, not skill.
Gain needed to recover from a drawdown DD = 1/(1 - DD) - 1.

3. Evaluate a manager's investment philosophy and decision-making process, and the behavioural factors that can affect the investment team.

A credible philosophy names the inefficiency exploited, why it persists and when it will not work.
Process must be consistent with philosophy: holdings, turnover and attribution should match the story.
Average holding period is roughly 1 / annual turnover.
Assess depth, stability, succession and incentives, not just the star manager.
Team biases include overconfidence, confirmation bias, the disposition effect, groupthink and escalation of commitment.
Look for working safeguards such as written pre-meeting views and devil's advocates.

4. Compare pooled investment vehicles with separately managed accounts, and interpret the main terms of investment management contracts.

Pooled vehicles: low minimums and simple administration, but no customisation and exposure to co-investor redemptions.
SMAs: direct ownership, customisation, transparency and easy transition, at higher minimums and cost.
Lockups, notice periods and redemption frequency set how quickly capital can be withdrawn.
Gates cap withdrawals per period and are met pro rata; side pockets ring-fence illiquid assets.
Key-person and most-favoured-nation clauses protect investors; liquidity terms must match the assets.

5. Analyse performance-based fee structures and interpret a manager's fee schedule.

Tiered ad valorem fees are simple but reward asset growth; effective rate = total fee / assets.
High-water marks stop the investor paying twice for the same gains.
A hard hurdle charges incentive fees only on returns above the hurdle; a soft hurdle charges on all returns once cleared.
Fulcrum fees are symmetric around a base fee, usually with a cap and floor.
One-sided incentive fees are call options for the manager and can encourage excess risk, especially below the high-water mark.
Compare structures by the investor's net return across low and high gross-return scenarios.

Module at a glance

Selection runs from defining the need through screening, investment and operational due diligence, terms and monitoring.
Type I error = hiring or keeping an unskilled manager; Type II error = passing over or firing a skilled one; stricter screens trade one for the other.
Returns-based style analysis gives the effective style mix; selection return is measured against that style benchmark.
Capture ratios and maximum drawdown show how a manager behaves in falling markets; recovery gain = 1/(1 - DD) - 1.
Judge philosophy, process and people for consistency; holding period is roughly 1/turnover; watch for groupthink and overconfidence.
SMAs offer ownership, customisation and easy exit; pooled vehicles offer scale but carry co-investor and liquidity risk; gates pay pro rata.
Performance fees need high-water marks, hurdles or symmetry to align interests; compare net returns across scenarios.

This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.

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