The Importance Of Manager Selection Within The Alternative Investments World by John Dolfin, CFA Chief Investment Officer and Christopher Maxey, CAIA® Senior Portfolio Manager, Steben & Company
Given the increasingly complex world of alternative investment products (alts), we will discuss in this white paper the importance of manager research and due diligence.
Investors of all stripes recognize that choosing the right fund managers may matter a great deal more going forward than in the past, when passively owning a diverse array of assets generally achieved longer-term objectives.
Traditional alts such as hedge funds have evolved from a modestly-sized investment niche in the 1990’s to a more fully embraced “asset class” sought after by institutional investors, especially after many hedge funds delivered positive performance during the equity bear market of 2000–2002. More recently, with the introduction of ‘40 Act “Liquid Alternatives” that are convenient and accessible to non-accredited investors, interest and demand for these products continues to grow. This growth is understandable. In a post-quantitative easing environment of frothy equity valuations and ultra-low fixed income yields, investors are challenged to make returns within a traditional portfolio context.
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Framing The Alts Analysis Dilemma
Previously, in the long-only mutual fund and ETF world, an investor would try to choose the right style of manager to fit a given environment. Think of a Morningstar style box where a given equity manager resides somewhere within the spectrum of specializing in small-cap versus large-cap; growth versus value; and international versus domestic. Once an investor placed an allocation, that investor would have a well-defined ability to benchmark each manager against an appropriate style index. Diversify across asset classes, styles, sectors and geographies and a well-balanced portfolio could generally be produced.
However, trying to place an alternative fund into a simple categorization can lead to a messy outcome due to funds having a multitude of distinguishing characteristics. These include single-manager versus multi-manager choices, mixed equity beta profiles, and different strategy intentions. Alternative investment managers are much less constrained than traditional asset managers, and therefore tend to deliver more dispersion in their return profiles.
So how should one compare and benchmark alternative funds? Is examining a Morningstar or other database tear sheet really enough? And while there certainly may be more product choices in the alts space today, might investors ultimately emerge less satisfied from their alternative investment choices?
The Goal & Purpose of a Fund of Funds Manager
The answers to these questions can be found in the following assertion: a quantitative comparison of alternative managers must be supplemented with solid qualitative due diligence and a diversified set of managers. Historically, fund of funds (FoF) firms filled this role, and regardless of whether the FoF’s ultimate product is delivered to investors in a Limited Partnership, a Closed-End Fund, or a Mutual Fund vehicle, the definitive goal is to offer both manager selection expertise and access to a diversified blend of quality managers that an investor otherwise might not be able to find and/or could not access due to large minimum investment requirements.
Expressed another way, the purpose of a FoF is to improve the chances of picking managers that perform better than average on a risk-adjusted basis over the long run. The fees of a FoF vehicle may certainly be worthwhile to investors if it helps them avoid “bad apple” hedge funds that take unacceptable risks or are outright frauds.
The FoF vehicle becomes even more valuable if, via appropriate manager diversification, it can deliver a resilient return stream across a variety of different market environments.
Such a result generally requires a repeatable investment process and a practiced balance of manager selection and portfolio construction. And not every FoF firm does both well. The remainder of this paper will address requirements for those that can adequately marry both disciplines.
Proper Due Diligence & Diversification is Paramount
Proper Due Diligence of Alternative Managers Goes Far Beyond “Checking The Box” of Desired Manager Attributes
Moving from database screening, to extensive in-person interviews, followed by a variety of other follow-up analysis, the basic goal is to answer four overriding questions of any given manager:
- Can a manager be trusted?
- What sets this manager apart from others, and what risks are inherent to the approach?
- Is a manager skillful enough to deliver actual alpha?
- Does the manager offer a natural fit within the overall portfolio?
Can a manager be trusted?
The first of these questions obviously involves a heavy modicum of qualitative judgment, but the key is to maintain objectivity and avoid chasing managers based solely on past performance. The tenure of a given manager, the overall organization of a firm, the position-level transparency offered, and thorough reference checking can help supplement the subjective impression that a given manager exudes. Can a manager articulate a clear philosophy and investment methodology that makes sense and credibly fits a fund’s past track record? If a manager is difficult in the interview process, the manager seldom becomes easier to deal with later on. And with so many different funds to select from, a good rule is to “Avoid hubris, ego, and lack of transparency.” This toxic trio of factors tends to end badly and it is often prudent to just say: “Next.”
What sets this manager apart from others, and what risks are taken with that approach?
The second question delves deeply into the nature of the investment strategy, and focuses on issues of risk unique to that strategy. These include concentration risk, directionality risk, complexity risk, illiquidity risk, and leverage risk. It is important for a manager to avoid being overly restrictive in managing the portfolio, thereby hampering their ability to deliver attractive returns. However, a manager should also not act recklessly or take unreasonably large risks. Either path could lead to fatal mistakes. Ideally, there should be a reasonable balance of risks taken to generate returns in a sustainable fashion over time. The purpose of risk management is to help a manager become rigorous, repeatable, and consistent.
Is a manager skillful enough to deliver actual alpha?
An assessment of a manager’s skill is important because skill is more likely to lead to sustained long-term outperformance, while luck generally runs out in due time. Strong past performance is not always an indicator of skill. It is important not to confuse a benign environment for true skill. As a simple example, compare a long-biased equity long/short hedge fund with a low net-exposure equity long/ short fund. In an equity bull market, the long-biased fund may well be the outperformer of the two. But this is not necessarily due to greater stock selection skill. The long-biased fund had the wind at its back during a rising market. In a flat stock market, the long bias is of no advantage, and in a falling market, it is a headwind. In the long run, over a full market cycle, a more skilled low-net exposure manager may well perform better than a long-biased manager.
Skill also involves the ability to adapt to evolving market regimes, although we would caution that too much style drift leaves the investor uncertain of the manager’s expected return profile over time.
Does the manager offer a natural fit within one’s overall portfolio?
The fourth question is specific to a desired return profile and investment goals of the particular portfolio. If a FoF is designed to be a diversifier to a traditional long equity and long bond portfolio, it should include a proportionally larger allocation to managers with low betas and low correlations to equity and bond indices. Furthermore, in order to reduce the volatility and improve the Sharpe ratio of a multi-manager portfolio, it is advantageous to select managers with low correlations to each other. When considering a new manager, one should ask, what purpose does a manager potentially serve and does it duplicate exposures already in the portfolio? Is that manager a core allocation, a peripheral allocation or otherwise useful as a hedge? At this point, it is common to utilize quantitative tools that may reveal various style biases for a given manager that are not always intuitively obvious. It is also important to ensure that a given manager remains the strongest choice in a given strategy or style after making the allocation. It is crucial to build a style peer group for every given manager, and then to monitor each manager in relation to those peers.
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