“We don’t think we were wrong. We think we were early.”
A cringe-worthy answer that rings alarm bells for investment consultants.
Higher inflation, increased market volatility, and more variable nominal interest rates are significant opportunities for active managers who can demonstrate their value with differentiated, customer-centric products. But with active management under ongoing scrutiny, investment managers are being caught off guard by tougher questions from an increasingly sophisticated allocator market. Are you prepared for your next beauty parade?
The Changing Conversation Between Allocators and Managers
I recently sat down with manager selection experts Evan Frazier and Joe Wiggins. During our conversation, they shared the tough questions that investment consultants and asset allocators are now asking prospective managers. Frazier, CFA, CAIA, is a senior research analyst at Marquette Associates in Chicago and Wiggins is director of research at St. James’s Place in London and author of a popular blog about investor behavior.
The following are four of the most productive and challenging questions, as well as the motivation behind them.
If you were to run your strategy systematically as an algorithm, how would you do it?
Wiggins looks at three main aspects when evaluating a portfolio manager:
- The manager’s beliefs about markets and their competitive advantage,
- The manager’s decision-making process and its consistency with their beliefs, and
- The outcomes generated by those beliefs and processes.
This question focuses on the manager’s process. The manager’s answer reveals the extent to which they have thought through the best use of their human energy, and the extent to which they have embraced technology to do the things that can be done systematically.
What are some mistakes you’ve made throughout the strategy’s history or your tenure? How have you reacted?
“Every PM loves to talk about — and can talk about — the winners that they’ve had,” Frazier notes. “But I think it’s helpful to get a sense of when things may not have worked out.”
Allocators want to hear, and ideally see evidence, that the manager has reflected on their mistakes without just blaming bad luck. They are interested in understanding what lessons were learned and how those insights are being applied to achieve better outcomes in the future. Demonstrating humility, accountability, and objectivity goes a long way with sophisticated investors in this day and age.
Assuming recent performance is not necessarily a good indicator of your actual skill level, how do you measure the success of your decision-making?
This is one of Wiggins’ preferred questions from an outcomes perspective. He’s not looking for a specific answer. He wants to know if the fund manager has thought about this question because it provides insight into the philosophy and approach behind their strategy.
“If they were taking a view that headline performance was all you needed to know to assess whether someone had skill or not, I would be incredibly skeptical,” he says.
This gets to the heart of our Behavioral Alpha Benchmark: It looks beyond the historical returns and the effects of luck to measure a portfolio manager’s demonstrated skill across a range of investment decision types.
How has your investment process evolved over time?
Frazier and Wiggins agree on this one. Investors want to see that the manager is consistently making decisions that are aligned with the fund’s philosophy, but they also expect the investment process to evolve as technology advances.
“Clearly no investor has got an unimpeachable or perfect process,” Wiggins remarks, but he cautions that a change to process should not be based solely on a single, painful example. “You really want to build up an evidence base and recognize patterns in your process and decision-making about where you can potentially make enhancements.”
More and more, active managers are realizing that there’s no longer a competitive advantage to being smarter than everyone else or even to having access to better information. As I’ve discussed previously, what’s left is “behavioral alpha” — the excess returns that can be generated by “knowing thyself” and being more focused on self-improvement than the next person. And that starts with asking yourself hard questions.
It’s clear that the landscape of active fund management is shifting. Transparency is increasing, data is more accessible and cheaper alternatives abound. Managers who are caught off guard by the tougher questions being asked by the sophisticated end of the allocator market are at an avoidable disadvantage. The good news is that a new generation of both allocators and fund managers is more committed than ever to continuous improvement, fostering true partnerships and doing their best for end investors.
