The 6th annual international fund manager selection conference brought together about 100 participants from all over Europe both from the buy as well as the sell-side. Interesting topics about what fund manager selection is about were presented. The future of open architecture was discussed in the context of a changing and more regulated world. Trends towards fundamental indexing were presented and the evolution of traditional asset classes, like fixed income and equities depicted.
On September 25th and 26th was held the 6th international fund manager selection conference. I had the chance to being invited by the organizer to attend this very interesting event. Upfront I was mainly interested in hearing about how to select talent or skill. But during the two days conference I got an overview that there are different perceptions on what fund manager selection should be about, mine unfortunately not being the dominant one. In this short blog I summarize my subjective impressions from the event.
What is manager selection all about
One of the topics that was part of most presentations was implicitly or explicitly defining what fund manager selection is all about. The two predominant definitions were:
- Fund manager selection is predominantly selecting fund managers that adhere to a specific investment style which the selecting agent believes will be successful in the future. A simple example could be selecting a value based large caps equity fund manager. The skill of the selected manager subsumes to adequately defining his/her style and adhering to it.
- Fund manager selection is predominantly screening a large database selecting fund managers based on a given set of criteria, like track record, assets under management, company profile, credible investment team, etc. The main focus is on a sound and repeatable process. Investment performance, or what I call forecasting skills, is only one component of the screening process. In some screening processes, especially those run my investment consultants, forecasting skills do not play a significant role, if any.
During a panel discussion, senior fund manager selection professionals focusing on private clients discussed the development of the open architecture concept for the private banking business model. Key insights I took from this panel discussion are:
- Interestingly the panelists did not see any major differentiating factor in implementing an open architecture fund manager selection business model, except for the degree of openness of the platform, that is, how many fund providers participate.
- In general the investment horizon is short term due to the clients’ required short time reporting horizon. In addition there exists a need for turnover generation from the advisory side.
- The selection process is primarily driven by asset allocation decisions rather than by searching for manager skills.
- The goal is to avoid the bad funds, rather than select stars.
- Panelists agree that the focus for selecting funds should be on selecting the right product for the client. But the panelists were unable or unwilling to exactly define what the right product means.
- In most private banks the selection process can be summarized in two steps: 1) funds are selected based on their exposure matching the private bank’s asset allocation and the client needs, 2) the selection is refined using league tables based on various criteria, mainly related to past performance.
- Some private banks restrict their open architecture to a small (10 to 20) number of fund providers in order to reduce the complexity for their advisors.
- Most of the panelists see the future in private banks selecting the themes and fund or asset managers providing exposure on a segregated account basis.
A topic that was (unfortunately) missing from the discussion was the impact of regulation on the open platform model. The fee transparency required by the regulator may have a significant impact on the open architecture business model. If a private bank is no longer allowed to receive retrocessions from third party providers, what incentivation should it have to select external rather than internal fund providers, especially if both options exist? A key question will be to see to what extend clients can impose on their private banks an open architecture model? Your thoughts on this topic are highly appreciated, either online or offline.
The meaning of skill
In one of the few presentations that focused primarily on investment skill Eddie Stuckie from Towers Watson introduced an innovative approach for evaluating manager skills based on Bayesian statistics theory. Indeed, past performance of a manager, under this model, changes the probability of picking a star rather than flop over time. In addition, there exists a good chance that performance is mean reverting, that is, if a star manager has underperformed, the chance is increased that, in the future, he will outperform. Therefore it is a bad idea to fire a manager that has performed poorly over a period of time, assuming that, apart from the track record the manager is still considered to be a star manager. Similarly, hiring managers with strong track records may be a bad choice as the probability is high that they will exhibit poor performance in the near future under the mean reverting assumptions.
Another interesting definition of investment skill from the investor’s perspective was given by Prof. Rajan as being trust, defined by
trust = forecasting skill (track record) + culture (incentive alignment) + structure (nimbleness).
I find it always interesting at conferences to try to find out what future trends in the industry could be. My main conclusions are that there exist evolving paradigms on the characteristics of gaining exposure to major assets, mainly fixed income and equities. In addition, so called engineered indexing seems to be a topic of the future, where the added value is in the up-front investment engineering capabilities rather than the ongoing investment management skills. Interestingly the following trends could also be identified:
- Especially institutional investors are less inclined to outsourcing. There seems to be a trend towards insourcing and away from open platforms.
- On the asset class side, the trends seems to be towards less equities and more fixed income, mainly credit, reducing risks in the portfolios.
- In addition less domestic investments and more diversified growth, that is, high tracking error balanced products seem to be thought after.
- Finally a dangerous trends seems to point to less due diligence at the manager level because of increased regulation and cost cutting.
But let me start by looking at an investment opportunity that has been in discussion for some time, volatility.
Volatility as an investment opportunity
Prof. Rajan presented a study done by CREATE Research entitled “market volatility: friend or foe?” The result presented suggest that volatility should be considered as an investment opportunity along any one of the three dimensions
- uncertainty management, meaning managing the risk stemming from shocks in the system rather than from probabilistic analysis
- diversification, considering alternate sources of return that exhibit low correlation to equity and fixed income markets, and
- manager selection, aiming at investment capabilities and performance persistence with a specific focus on selecting those managers that make the least mistakes (winning the loser’s game).
The ideas presented can be summarized by the quote
Figure 1 shows, according to the study, the evolvement of how institutional investors (and also private clients) are and should structure their wealth.
Fixed income world
According to various speakers, the fixed income world seems to evolve in increasing order along
- duration management
- global and credit diversification
- fundamental indexing
- alternative strategies / universes (cat-bonds, ILS, …)
- yield enhancing asset classes
In the equity world, portfolio will be structured as a combination of three different types of equity portfolios:
- Defensive strategies with β < 1: minimum variance, fundamental indexing, high dividend, …
- Passive global market exposure with β = 1
- High risk / high return markets β > 1: small caps, emerging markets
In general a trend is seen towards rule based indices implemented using indexing techniques as shown in Figure 2.
Although I did not gain much insight into how to identify skill and talent during the conference, it nevertheless gave me an interesting overview on how the fund manager selection industry thinks and works.