Section 5 - R27 - Investment Manager Selection Flashcards
Key Asspects in Manager Selection (List)
- Define the universe (suitability, style, active or passive)
- Quant Analysis (track record, capture ratios, attribution and appraisal, drawdown)
- Qualitative Analysis:
- Investment Due Diligence (philosophy, process, people)
- Operational Due Diligence (philosophy, investment vehicle, terms, monitoring)
Types of Errors in Investment Manager (List and Explain)
H0: Investment Skill = 0
Error Type 1: H0 is true. Error is to reject and CHOOSE manager.
- Should have rejected manager
Error Type 2: H0 is false. Error is to NOT reject and AVOID manager.
- Should have accepted manager
Errors Type 1 and Type 2 implications (Describe)
Type 1: Errors of Comission.
- Should have rejected manager.
- Hired underperforming manager.
- Psychologically more painful.
- Cost: Explicit. More transparent.
Type 2: Error of Omission.
- Cost: Opportunity (Comission)
- If consistent error, shows weakness of the investment manager selection process
Difference in expected cost between Type I and Type II (Describe)
Higher the smaller the perceived difference between the distribution of skilled and unskilled managers.
Quantitative Elements of Selection (List and Describe)
- Style Analysis
- Returns Based Analysis
- Holdings Based Analysis
- Style Analysis
- Style Analysis: Understanding
the manager’s risk exposures relative to the bench + how they evolve over time.
Must be:
- Meaningful (reported risks must represent important sources of risk exposures)
- Accurate (must reflect actual risk exposures)
- Consistent (methodology must allow for comparison over time)
- Timely (information should be timely)
- Returns Based Analysis
- Top down approach
- Estimate portfolio’s sensitivities to security market indexes representing risk factors
Pros: easy to manipulate, not too much data to compile
Cons: imprecise, not accurate, may not reflect future holdings, illiquid holdings may have stale prices
- Holdings Based Approach
- Bottom up approach
- Point in time analysis
Pros: Comparable across managers and through time
Cons:
- Complex
- Subject to window dressing
- Requires Transparency
- May not reflect portfolio going fwd
Qualitative Elements of Selection (List and Describe)
- Investment Philosophy: Manager’s underlying assumptions that drive the investment performance, including inefficiencies
- Investment Personnel: Is there sufficient personnel with the adequate experience and expertise?
- Investment Decision Making Process: Signal creation, signal capture, portfolio construction, monitoring.
- Quali: Investment Philosophy (Describe)
Manager’s underlying assumptions that drive the investment performance
- Strategy:
- Passive (Premium = f factors)
- Active (Premium = f mispricing)
- Inefficiencies:
- Behavioral (temporary)
- Structural (Permanent)
- Other Assumptions:
- Market Convergence
- Correlations
- Macro Influence
- Investment Personnel
- Sufficient experience, expertise and depth?
- Is there key person risk?
- Turnover
- Investment Decision Making Process
a. Signal Creation: Generate idea
b. Signal Capture: Translate in an investment idea. Repeatable?
c. Portfolio Construction: Implement Position
d. Monitoring.
Investment Vehicles (List)
- Individual Separately Mgd Account
- Pooled / Comingled Vehicle
9.
- Individual Separately Mgd Account (Describe)
- Individual Separately Mgd Account
- Ownership: Não afeta outros investidores. Clear legal ownership.
- Customization: Accomodate constraints / preferences
- Tax Efficiency: No other withdrawals
- Transparency: Real Time Information
Cons:
- Escalation issues
- High costs
- Tracking Risk (Customization)
- Attribution messy due to constraints
- Pooled / Comingled Vehicle (Describe)
- Money from multiple investors held as a single portfolio
- No customization
Vehicles Liquidity (List)
- Most Liquid: ETF
- Open-ended funds
- Limited Partnerships (HFs)
- Private Equity & Venture Capital
Hedge Funds Liquidity Characteristics (List)
- Redemption Frequency
- Notification Period
- Lockup (hard or soft, w/ penalties)
- Gates (limit amounts withdrawn at redemption date)
Limited Partnership (Pros and Cons)
Pros:
- May hold illiquid assets
- Reduced risk of having to sell at bad times
- Removes potential for overreaction
Cons:
- Less flexible
- Less liquid
Terms of Investment (List of Items)
a. Liquidity
b. Management Fees (for operating and fixed costs)
c. AuM Fee (to retain capital and increase asset value)
d. Performance Based Fees
Performance Based Fees (List and Explain)
1) Fully exposed to upside and downside (Ex: Mínimo +- 25bps)
2) Bonus structure with limited downside. Mínimo + Upside ilimitado (Ex: Mínimo + 20% do upside). Nunca menor que o mínimo.
3) Bonus with limited upside and downside. Not necessarily simmetrical.
Ex: Curva S do Itaú BBA
Performance Fees Characteristics (List)
- Paid annually
- High watermarks
- PE, HF and Real Estate funds unlimited
- If managers control profit realization, they may have an incentive to hold on to assets until profit is realized
- HF managers may want to sell funds if they are already below water mark (mv portfolio < high water mark)
Quantitative Analysis in Selecting Manager (List)
- Track Record
- Capture Ratios
- Attribution and Appraisal
- Drawdown
Qualitative Analysis in Selecting Manager (List)
- Investment Due Diligence (Philosophy, Process, People)
- Operational Due Diligence (Philosophy, Investment Vehicle, Investment Terms, Monitoring)
How Performance Based Fees Impact Volatility?
Performance-based fee structures convert symmetrical gross active return distributions into assymetrical net active return distributions, reducing variability on the upside but not the downside, providing miscalculation in risks
Standard Fee (Concept)
If you achieve (a) breakeven active return, you will pay (b) standard fee.
Net Active Return (Formula)
(a) Net Active Return = Active Return - Billed Fee
(b) Billed Fee = Base Fee + Additional Participation Fee * (Active Return- Base Fee)
Which Manager’s Fee Structure is Similar to a Call?
Bonus-style fee with a maximum fee feature. It is the most similar / equivalent to a call option on a share of active return for which the base fee is the strike price minus another less valuable call option with a strike equal to maximum fee.
