Clients often ask us to describe our manager research process from start to finish, and while we can illustrate this, we will note that the process is an ongoing and interactive one.
During the process feedback loops between markets, existing investments, prospective holdings and risk and return considerations will occur and constantly shape our decision.
Therefore it can be spurious to talk about the start and end points in the selection of an investment manager as the process starts well before a track record is reviewed, a request for proposal is read and a research meeting is arranged. It is first important to determine whether these activities are likely to bear fruit by considering the ‘opportunity for active management’.
This framework is designed to ensure that we fish in the right ponds, as it is critical that time and effort is spent in areas where it will be most fruitful, in terms of net-of-fee return generation for our clients.
We do this by thinking about the characteristics of an asset class that increases the likelihood that active management will pay off. Broadly, these can be put into four groups of factors: asset class structure; the quality of market participants; the quality of information flow and cost considerations.
The structure of an asset class will determine whether active bets have more or less chance of paying-off. If the investment universe is broad and not concentrated in nature, then the number and size of positions that can be taken is increased and the opportunity to add value, for a skilled manager, is enhanced. When Nokia dominated the Finnish equity market, or Nortel dominated in Canada, it would have been a difficult time to be an active manager in these two markets. The same, when cross-sectional volatility is low and stocks move in lock-step, active positions incur costs and reap no reward.
Under the ‘quality of market participants’ heading, it is important to consider such things as the size and diversity of the peer group operating in an asset class, as well as the aggregate performance of these managers. If more managers ply their trade in one area versus another, it might point to increased efficiency and less to go for in an active management sense. If diversity of investment approaches employed is low, it might suggest that there are fewer opportunities to efficiently diversify manager-specific risk when creating mixes for our clients. Some of the vanilla fixed income asset classes might fit the bill in this respect.
Finally, the price paid to access a manager’s investment insights will clearly impact returns. Management fees can make a significant dent in returns, as can taxes, such as stamp duty in the UK, periodically imposed investment restrictions that we have seen in some of the less-developed capital markets, or hidden costs, such as trading spreads and commissions. Where these hurdles exist, investing is that much harder.
Once these factors have been considered, an investor is better informed about where to fish, comforted by the knowledge that they have not cast their net too widely.
Rob Hall is head of multi-manager at Schroders