Investment Manager Selection

Question 1

What are the components of the quantitative due diligence process?

Answer 1

1. Attribution and Appraisal of risk and returns
2. Capture ratio
3. Drawdown

Question 2

What are the components of the qualitative due diligence process?

Answer 2

1. Philosophy
2. Process
3. People
4. Portfolio - do you stick to your philosophy?

Question 3

What are the components of the operational due diligence process?

Answer 3

1. Process/Procedure
2. Firm (culture, profitability, going concern)
3. Investment Vehicle
4. Terms
5. Monitoring

Question 4

What is the difference between type 1 and 2 errors in the context of selecting investment managers?

Answer 4

Type 1 errors are errors of commission - you attribute skill to someone when it does not exist
Type 2 errors are errors of omission - you rule someone out who has skill

Question 5

Which type of error is more psychologically painful, Type 1 or 2?

Answer 5

Type one as opportunity cost is less painful than explicit costs

Question 6

What are the advantages and disadvantages of returns based style analysis?

Answer 6

Returns based analysis can be run by simply having the time series of data and is therefore pretty easy. It is easy to compare across managers. The downside is that it measures and attributed returns to characteristics in a point of time when characteristics are typically dynamic. It will not be suitable when you have illiquid securities that have understated volatility. You also need a decent sample size of data.

Question 7

What are the advantages and disadvantages of holdings based style analysis?

Answer 7

Holdings based analysis is a bottom up approach that evaluates each holding at a point in time. It provides an accurate representation of risk exposures as it can be tracked over time. It could be subject to window dressing. It will take much more time and often has time lag. It is typically easier with long equity strategies.

Question 8

A manager with high active share and high tracking risk is likely…

Answer 8

A concentrated stock picker

Question 9

A manager with high active share and low tracking risk is likely…

Answer 9

A diversified stock picker

Question 10

A manager with low active share and low tracking risk is a…

Answer 10

Closet indexer

Question 11

A manager with low active share and high tracking risk is a…

Answer 11

Sector rotator/top down manager

Question 12

What should you be looking to answer when evaluating a managers investment philosophy?

Answer 12

1. Can they articulate what they are doing?
2. Are the assumptions they make credible and consistent
3. How has their philosophy developed over time?
4. Are return sources linked to consistent inefficiencies?
5. Are returns repeatable after transactions cost?