Investment success or failure often hinges on one critical decision: choosing the right fund manager.
However, with so many managers available, it can be challenging to identify the right one — and making the wrong choice can be a costly mistake.
While choosing a fund manager can be daunting, following these practical tips can help you avoid the pitfalls of selecting the wrong fund manager and pave the way to better investment returns.
1. Find the Best Options
It’s essential to have both a broad and high-quality pool of candidates from which to choose. Investors should expand their search outside their immediate network. They can attend conferences, ask colleagues and service providers for referrals, look online, join professional networking groups, follow industry sources that track managers/analysts spinning off from firms, or subscribe to databases that monitor manager performance.
Investors must mitigate selection bias, an error in selecting individuals or groups to participate in a study. Selection bias exists due to a flaw in the sample selection process, wherein you systematically exclude options due to a particular attribute.
To avoid selection bias, don’t immediately filter out managers before you’ve gathered sufficient data on them. Yes, early-stage managers carry risk, but superstar established managers were also once new. Don’t ignore emerging managers who don’t have a track record that suits your preferences because you could be missing out on a hidden gem. You want to find those unknown managers who will perform beyond expectations. Look at more criteria to predict possible success by focusing on multiple asset classes (digital, fixed income, emerging market, etc., as well as multiple managers). A well-diversified portfolio across multiple asset classes helps ensure that your asset allocation decisions work in your favor.
2. Understand Their Track Record
In those cases where a previous track record does exist, either for an existing firm or a manager lifting out from another firm, investors must dig deep to determine exactly how the firm or manager generated that track record.
It’s critical to understand how the manager achieved those returns, drilling down into the market conditions in which they’ve worked, the decision-making structure, and the size of their fund.
In conducting due diligence on managers with a track record from a previous firm, you must determine:
- The exact role the individual had in generating returns: For example, were they the main decision maker or simply part of a team where others played a part in generating returns?
- Their track record: Are the measures that led to their previous success in place in this firm, whether those measures include investing with an established manager or a new manager? This is particularly important when evaluating portfolio managers or individuals who are starting up new firms. Do they have all the resources (including personnel, systems, access to quantitative models, and other tools) they need to replicate their previous performance? A manager’s history of success doesn’t always mean they’ll continue to succeed. In evaluating a manager’s previous track record, it’s important to fully understand if you have the same conditions and opportunities in place for their success.
3. Ascertain Their Distinct, Identifiable Edge
A track record alone doesn’t always tell the complete story of what has made a manager successful. You should look to the often-used disclaimer of “past performance is not indicative of future results” as you conduct the due diligence process.
While an impressive track record may help a manager get through the first round of due diligence, the manager’s ability to clearly articulate their edge is critically important. Have they explained to you — in simple terms — what makes them unique and worthy of your investment? Is this edge sustainable? What’s the short-term and long-term outlook for their edge? While no one can predict future performance, the manager should be able to explain under what market and economic conditions their strategy will both outperform and underperform. In being able to explain their unique competitive advantage, they should then be able to give you better insight into why they deserve an allocation.
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4. Confirm Alignment of Interests
Investors must also look for aligned interests. This alignment is particularly important when considering an investment in a fund structure. One important tell-tale sign of alignment is that the manager has skin in the game. The amount of personal wealth a manager commits to the fund is a strong indicator of how confident the manager feels in their future success. The terms under which the manager and team members invest in the fund should match your own.
Additionally, other fund terms, such as withdrawal frequency and liquidity, should be structured to ensure that the interests of all parties are aligned. Consider fees, employee compensation, and service provider arrangements as a further indicator that all parties are incentivized to ensure maximum success.
5. Review Management and Operational Risk
The ability to generate positive returns is only a portion of the story when considering making an allocation to a manager. Because legal, regulatory, and business risks also play a critical role in the success of a manager, it’s important investors evaluate and determine operational risks.
Investors must conduct Operational Due Diligence (ODD) on every manager. Cash management controls, the ability to meet client service needs, adherence to regulatory and compliance requirements, protection of client and employee data, and the ability to continuously operate are just some of the factors that you should consider when determining the suitability of a manager for investment.
When evaluating the suitability of new or emerging managers, you must focus even more directly on their ability to run and manage a business to ensure their ultimate survival. Check to see if the service providers with whom the manager chooses to work, often viewed as key business partners, have undergone a comprehensive and consistent due diligence process. Emerging managers face more operational risk than their established counterparts and therefore must demonstrate that they have the control systems in place to properly run the business side of things.
6. Document Your Due Diligence
Investors must document their due diligence, ensuring they have properly conducted this process in alignment with the manager’s investment capabilities and operational considerations. Arootah’s Fund Manager Selection Decision Manager app is one way you can ensure that you are considering the most important criteria in decision making. The app not only recommends factors that are most important in the due diligence process, but it also allows you to select the criteria most important to you, then affords you to weigh those criteria based on your individual needs.
Using the app, you can confidently show your LPs or committees your thought process surrounding due diligence for each fund manager. The Decision Manager app simultaneously guides you through a documentation process based on both industry best practices and your personal criteria.
7. Conduct Ongoing Due Diligence
Once you complete your initial due diligence and make an informed decision on a manager, the process still isn’t over. You must now begin an ongoing process in which you regularly and consistently review what the manager told you.
Ultimately, the manager’s performance should serve as a benchmark you can use to determine whether you made the right choice. You must regularly review their ability to meet your service needs, retain the employees and staff they indicated they needed to manage the business, and meet regulatory obligations. Is the manager committed to the process they sold you during the interview process so that there are no surprises?
Make sure you have a process in place to consistently run the checks and balances you need to confirm they’re indeed doing what they said they would.
The Bottom Line
While choosing a fund manager can be daunting, following these seven practical tips can help investors mitigate the risks of choosing the wrong one.
Selecting the right fund manager requires thorough research and analysis. Investors must have a broad pool of candidates, avoid selection and survivorship bias, dig deep into a manager’s track record, ensure an alignment of interests, evaluate management and operational risks, and document their due diligence. By following these tips, investors can reduce the risk of selecting the wrong fund manager and increase their chances of generating higher returns.
Ready to make informed investment decisions? Arootah Business Advisory offers expert guidance to support you in choosing the right fund managers. Our advisors can walk you through our proprietary Manager Selection Decision Manager app, the same model Arootah CEO/Founder and Blue Ridge Capital COO/Co-Founder Rich Bello used for years to invest in managers and make critical decisions. Book a free consultation today to get started.
Disclaimer: This article is for general informational purposes only and does not constitute legal, investment, financial, accounting, or tax advice, or establish an attorney-client relationship. Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog, or anywhere else on our website.