Time vs. money trade-off

“For every complex problem there is an answer that is clear, simple, and wrong.” – H.L. Mencken

Active Manager Due Diligence Heuristics

Whether you consider them useful guidelines or overused clichés, rules of thumb abound in active manager selection. They even move in and out of popularity, depending on the priorities of the day. In this Insight, we examine some of the most commonly espoused principles with a critical eye.

NB: This discussion is focused on the evaluation of public equity and fixed income strategies. However, investors in illiquid asset classes may still find it of interest, as many of the principles apply more widely.

Our general message is that rules of thumb can be dangerous, especially when they are given too much weight in a due diligence process. Specifically, asset owners and consultants sometimes rely exclusively on a rule of thumb to screen managers in or out of a process. An example of this would be excluding managers with expense ratios above the peer median from any consideration, based on a belief that higher-cost managers deliver lower net performance. Before relying heavily on a rule of thumb, it’s well worth taking the time to formally assess the logic behind it, and determine whether or not it applies to the situation at hand.

It’s easy to discard a clearly wrong heuristic, which can be convincingly shown to be false. The trouble is, it’s rarely that simple in practice: most rules of thumb have some truth to them, as you might expect from any principle that garners wide acceptance amongst a group of very intelligent people. This makes it tricky to figure out whether a given rule should be treated as a useful guidepost, or a red herring.

Fund Selection Rules and Their Exceptions

Two forms of “truth” warrant particular caution when considering rules of thumb:

  • Truth on average. The fact that a principle is true more often than not generally does not make it very helpful as a rule to inform individual decisions, especially when exceptions are very common.
     
    For example, it’s true that there’s an inverse correlation between fees and performance net of fees. This is because most managers lack alpha generation ability, and so the higher the fee, the larger their underperformance. It does not follow, however, that a screening criteria like “bottom-quartile fees” is a good one — we explore why in the report.
     
  • Contingent truth. A principle may be reliably true only when one or more other facts are also true. Knowledge of these conditions can make the rule of thumb valid to use, while failing to take them into account can lead to errors.
     
    For example, we show that high portfolio concentration can lead to superior performance, but only if there’s high confidence that the manager is truly skilled at security selection — a critical caveat! A highly concentrated and unskilled manager can be a recipe for disaster, so it’s important to know which contingency you’re in before trying to apply the rule.
     

Reviewing the Rules of Thumb

With this background in mind, we list below some common rules of thumb. For each rule, we summarize the following:

  • Whether the rule is strictly true, by which we mean literally true, if all else is held equal.
  • Whether the rule is true on average, based on third-party studies as well as our own research where applicable.

In our full report, we provide the complete rationale for the above factors, as well as highlight important contingencies that apply when considering the rule as a screening or selection criteria.

The rules we address here are:

  • Lower Fees Are Better
  • Higher Active Share/Tracking Error is Better
  • Higher Portfolio Concentration is Better
  • Lower Turnover (Trading) Is Better
  • Higher Historical Performance is Better
  • Lower Assets Under Management (AUM) is Better
  • Longer Track Record is Better
  • There is More Potential Alpha in Small Caps Than Large Caps
  • There is More Potential Alpha in Emerging Markets / Frontier Markets than Developed Markets

To suggest an additional commonly used rule that you think merits consideration, please get in touch.

Lower Fees Are Better

This heuristic states that lower-fee managers should be preferred over higher-fee managers; fees are usually measured relative to a peer group or category average. The rationale is that there is no positive correlation between fees and net performance; in other words, higher-priced managers do not generally compensate for their fees by delivering superior performance.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly TrueTrue on AverageImportant Contingencies

Conclusion: Not Recommended for Initial Screening.

Why?   Download full report.

Higher Active Share/Tracking Error is Better

This heuristic states that running a high active share or tracking error is a positive indicator of active manager skill, and that “benchmark-hugging” managers should be avoided. The rationale is that a manager’s willingness to take active risk is a signal of conviction in informational advantage. Furthermore, it is argued that if passive exposure can be cheaply obtained, allocation to active strategies should be reserved for portfolios that look “different” from the benchmark.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly UntrueTrue on AverageImportant Contingencies

Conclusion: Not Recommended for Initial Screening.

Why?   Download full report.

Higher Portfolio Concentration is Better

This heuristic states that concentrated portfolios (in terms of number of positions and position size) are preferable to highly diversified portfolios. The rationale is that managers have a finite number of “best ideas”, and so if they manage a concentrated portfolio, they can invest only in their best ideas. By contrast, managers with a large portfolio are forced to “backfill it” with less-promising positions, which creates a performance drag.  A secondary rationale is that because concentration increases active risk, a manager’s willingness to run a concentrated portfolio is a positive indicator of conviction in his or her informational advantage.

Empirically Verdict

Literal TruthAverage TruthContingencies
AmbiguousTrue on AverageImportant Contingencies

Conclusion: Suitable for Use in Initial Screening with Contingencies Incorporated.

Why?   Download full report.

Lower Turnover (Trading) Is Better

This heuristic states that low turnover is associated with better performance and is a positive indicator of manager skill. The rationale is that excessive trading is costly for investors in the form of commissions and slippage, and can also be tax inefficient. A secondary rationale is that frequent trading can be an indicator of low Portfolio Manager conviction and/or a lack of informational advantage, if managers are quick to sell underperforming positions and/or are frequently being proved “wrong” by the market.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly UntrueUntrue on AverageImportant Contingencies

Conclusion: Not Recommended for Initial Screening.

Why?   Download full report.

Higher Historical Performance is Better

This heuristic states that past performance is an imperfect, but still useful indicator of future results. Some active managers possess skill which, over time, will be manifest in the form of a persistent performance advantage. Therefore, strong past performance indicates that a manager may be skilled. However, this rule of thumb may be implemented in many different and potentially conflicting ways, depending on the time period used and the choice of benchmark against which performance will be compared.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly TrueTrue on AverageImportant Contingencies

Conclusion: Suitable for Use in Initial Screening with Contingencies Incorporated.

Why?   Download full report.

Lower Assets Under Management (AUM) Is Better

This heuristic states that there are often diminishing returns to scale in terms of assets under management. The rationale is that higher AUM constrains a strategy’s opportunity set by reducing the number of potential investments with adequate liquidity, and increase transaction costs due to higher market impact and execution time. As a result, it is preferable to invest in smaller strategies which are not capacity constrained. This is one reason that some asset owners invest in “emerging managers”. However, the threshold of what should be considered high versus low AUM depends on the nature of the investment strategy as well as the size of the prospective investor. It should also be noted that in certain special cases – such as activist investing strategies – higher assets can be beneficial.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly TrueTrue on AverageMild Contingencies

Conclusion: Suitable for Use in Initial Screening.

Why?   Download full report.

Longer Track Record is Better

This heuristic states that a longer track record is preferable since it allows for more accurate assessment of a manager’s skill. The rationale is that the relative impact of runs of good or bad luck versus investment skill decreases over time, allowing for higher confidence in performance evaluation. A secondary rationale is that because poor-performing managers will tend to be weeded out by market forces over time, long tenure is an indication of a strategy’s quality.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly TrueUntrue on AverageImportant Contingencies

Conclusion: Suitable for Use in Initial Screening with Contingencies Incorporated.

Why?   Download full report.

There is More Potential Alpha in Small Caps Than Large Caps

This heuristic states that the value of active management is higher in small caps, whereas large caps are relatively better suited for passive indexing. The rationale is that smaller companies tend to be less heavily scrutinized than large companies, and so their securities are priced less efficiently. Therefore, it is easier for active investors to outperform a passive small cap benchmark than a passive large cap benchmark.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly TrueUntrue on AverageMild Contingencies

Conclusion: Not Recommended for Initial Screening.

Why?   Download full report.

There is More Potential Alpha in Emerging Markets / Frontier Markets than Developed Markets

This heuristic states that the value of active management is higher in emerging and frontier markets (EFM), whereas developed markets are relatively better suited for passive indexing. The rationale is that EFM companies tend to be less heavily scrutinized than DM companies, and so their securities are priced less efficiently. An additional rationale is that emerging and frontier markets face entail higher risks and offer fewer investor protections, and so it is more important to be selective as opposed to passively buying listed securities. The implication is that it is easier for active investors to outperform an EM or frontier benchmark than a passive developed market benchmark.

Empirically Verdict

Literal TruthAverage TruthContingencies
Strictly TrueUntrue on AverageMild Contingencies

Conclusion: Not Recommended for Initial Screening.

Why?   Download full report.

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Conclusion

Journalist H.L. Mencken famously remarked that “for every complex problem, there is an answer that is clear, simple, and wrong.” Unfortunately, this sentiment also applies to manager selection: given the huge diversity in investment strategies, blanket statements about the attributes of good or bad managers don’t perform well as decision rules.

While many rules of thumb are true on average – leading to their becoming rules of thumb in the first place – they all have a high percentage of exceptions, and most are only true under certain conditions. Therefore, a rule of thumb should never by itself form the basis for a decision to screen a strategy in or out of a due diligence process. Before using a rule, such as to form a criteria in a screening process, an evidence-based investigation should be conducted to establish the performance and predictive power of the rule in the type of decision under investigation – including the frequencies of false positive and false negative errors that it produces.


Author Information: Jordan Boslego is a Partner at Empirically.

Updated October 2020.