Title LM4 Investment Manager Selection IFT Notes.pdf ✅

LM4 Investment Manager Selection 2024 Level III Notes © IFT. All rights reserved 1 LM4 Investment Manager Selection 1. Introduction .......................................................................................................................................................2 2. A Framework for Investment Manager Search and Selection ........................................................2 Defining the Manager Universe .................................................................................................................4 3. Type I and Type II Errors in Manager Selection...................................................................................4 Qualitative considerations in Type I and Type II errors ..................................................................5 Performance implications of Type I and Type II errors ...................................................................6 4. Quantitative Elements of Manager Search and Selection.................................................................7 Style Analysis ....................................................................................................................................................7 5. Capture Ratios and Drawdowns in Manager Evaluation..................................................................9 6. The Manager’s Investment Philosophy................................................................................................. 12 Investment Philosophy .............................................................................................................................. 12 Investment Personnel................................................................................................................................. 14 7. The Manager’s Investment Decision-Making Process .................................................................... 14 8. Operational Due Diligence ......................................................................................................................... 16 9. Management fees........................................................................................................................................... 18 Summary ............................................................................................................................................................... 21 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM4 Investment Manager Selection 2024 Level III Notes © IFT. All rights reserved 2 1. Introduction When selecting an investment manager, two basic questions need to be addressed: • Does a manager display skill? • What is the likelihood that the manager will continue to display skills in the future? Evaluating an investment manager involves conducting due diligence. This analysis is done to understand and assess how the results were achieved and what is the likelihood of having superior or satisfactory investment results in the future. This reading covers three broad topics. Sections 2 and 3 outline a framework for investment manager search and selection. Sections 4 and 5 discuss quantitative considerations in manager selection. Sections 6 - 9 discuss qualitative considerations in manager selection. 2. A Framework for Investment Manager Search and Selection The framework for investment manager search and selection has three broad components: the universe, a quantitative analysis of the manager’s performance track record, and a qualitative analysis of the manager’s investment process. Exhibit 1 from the curriculum provides details about these components. Key aspects Key Question Universe Defining the universe What is the feasible set of managers that fit the portfolio need? Suitability Which managers are suitable for the IPS? Style Which have the appropriate style? Active vs. passive Which fit the active versus passive decision? Quantitative Analysis Investment due diligence Which manager “best” fits the portfolio need? Quantitative What has been the manager’s return distribution? Attribution and Appraisal Has the manager displayed skill? Capture ratio How does the manager perform in “up” markets versus “down” markets? Drawdown Does the return distribution exhibit large drawdowns? Qualitative Analysis Investment due diligence Which manager “best” fits the portfolio need? Qualitative Is the manager expected to continue to generate this return distribution? Philosophy What market inefficiency does the manager seek to exploit?
LM4 Investment Manager Selection 2024 Level III Notes © IFT. All rights reserved 3 Process Is the investment process capable of exploiting this inefficiency? People Do the investment personnel possess the expertise and experience necessary to effectively implement the investment process? Portfolio Is portfolio construction consistent with the stated investment philosophy and process? Operational due diligence Is the manager’s track record accurate, and does it fully reflect risks? Process and procedure Is the back office strong, safeguarding assets and able to issue accurate reports in a timely manner? Firm Is the firm profitable, with a healthy culture, and likely to remain in business? Is the firm committed to delivering performance over gathering assets? Investment vehicle Is the vehicle suitable for the portfolio need? Terms Are the terms acceptable and appropriate for the strategy and vehicle? Monitoring Does the manager continue to be the “best” fit for the portfolio need? Example: Components of the Manager Selection Process (This is Example 1 from the curriculum.) 1. Qualitative analysis of the manager selection process includes: A. attribution. B. defining the universe. C. investment and operational due diligence. 2. Which of the following is considered a key aspect of operational due diligence? A. People B. Philosophy C. Procedures Solution to 1: C is correct. Qualitative analysis consists of investment due diligence, which evaluates the manager’s investment process, and operational due diligence, which evaluates the manager’s infrastructure and firm. Solution to 2: C is correct. Process and procedures are key aspects of operational due diligence, whereas people and philosophy are key aspects of investment due diligence.
LM4 Investment Manager Selection 2024 Level III Notes © IFT. All rights reserved 4 Defining the Manager Universe The manager selection process begins by defining a feasible set of managers that fit the portfolio need. The objective is to reduce the manager universe to a suitable size, given the time and resources. This process of shortlisting managers involves balancing the risks of a very narrow search versus a broad search. The client’s IPS and the reason for manager selection determine the universe of managers considered and the benchmark against which managers are compared. Typically, the manager search starts with a benchmark that represents the manager’s role within the portfolio. This benchmark will be used as a reference for performance attribution and appraisal later. There are several approaches for assigning a manager to a benchmark: • Third-party categorization: Various third parties provide categorizations that assign managers to a strategy or sector (e.g., a large-cap value list). Though an easy and efficient method of defining the manager universe, there is a risk that the third- party definitions may be different from the portfolio’s role. • Returns-based style analysis: In this approach, we compare the returns of the desired benchmark and the returns of the managers being evaluated. If the return profile of a manager matches the benchmark, the manager is shortlisted. • Holdings-based style analysis: In this approach, we compare the holdings of the desired benchmark with the portfolio holdings of the managers being evaluated. If the holdings of a manager match the benchmark, the manager is shortlisted. • Manager experience: If a particular set of managers have been known to follow a benchmark, we can shortlist these managers based on their experience. The selection is based on observing their portfolio returns over time. 3. Type I and Type II Errors in Manager Selection Instructor’s note: In hypothesis testing, we set up two hypotheses – a null hypothesis and an alternate hypothesis. Typically, the null hypothesis is defined as the hypothesis that is presumed to be true until statistical evidence nullifies it for an alternative hypothesis. In simpler words the null hypothesis may be proven to be not true which we will reject in favor of the alternative hypothesis. Type I error occurs when we incorrectly reject the null hypothesis when it is true. Whereas, Type II error occurs when we fail to reject the null hypothesis when it is false. In the context of manager selection, the null hypothesis is that ‘the manager is not skillful,’ whereas the alternative hypothesis is that ‘the manager is skillful.’ The two types of errors in manager selection are: • Type I: Hiring or retaining a manager who subsequently underperforms expectations. Rejecting the null hypothesis of no skill when it is correct. • Type II: Not hiring or firing a manager who subsequently outperforms, or performs in line with, expectations. Not rejecting the null hypothesis when it is incorrect.