The Right Stuff
Best practices for assessing an investment manager’s process

By Jeff Brown, CFA, chief investment officer, Highstreet Asset Management Inc.

Have you ever wondered how to assess your manager’s investment process? To find out what standards are currently being used in the industry and what questions are being asked, I spoke with 60 industry participants including investment managers, consultants, plan sponsors, brokerage houses and industry service providers across the continent and abroad. I asked each one the same question, “What do you feel constitutes best practices within a quant investment process?” From there, I formulated a list of best practices, which are relevant to the industry at large, and have listed them below.

Convergence and definitional confusion
Traditional managers are increasingly using more quantitative techniques in their processes. As the gap between the art and the science sides of the investment business narrows, the question becomes, “what is quant anyway?” Due to convergence, a short list today often includes active quant shops and traditional money managers. The definitional confusion suggests that marketing efforts and short-list preparations should be examined whether your investment process is 80% quant and 20% fundamental or the other way around.

Quantification of the investment industry
The explosion in quantification has generated an overzealous use of measurable data. Best practices do not dictate that every conceivable statistic should now be measured, monitored and managed. We need to remember what Einstein said: “Not everything that counts can be counted, and not everything that can be counted counts." Best practices dictate that measures should be relevant to the mandate, transparent to the client, and consistently applied.

Growing reliance on forecasts and estimates
Many new statistics are being incorporated into investment processes and into due diligence. Many of these statistics are averages and represent a range of possible expected outcomes. But experience tells us that tremendous reliance is being placed on these measures, with little regard for the range. People are relying on the estimates and forgetting the error term.

Relaxation of traditional constraints
Increased client sophistication will drive down if not totally eliminate the current reliance on traditional mandate constraints imposed on managers. We are already seeing evidence of this development. Long/short funds and the currently popular 130/30 funds are examples of the long-only constraint being relaxed. Low investment returns and the increase in risk management sophistication used by plan sponsors have both played a role in this shift and it will have best practices implications. In addition to the delivery of alpha, managers will be expected to prove that the source of outperformance is appropriate for the mandate. As well, they will be expected to tailor their investment offerings to meet the varying risk budgets of their client set.

From this best practices study we believe that the quantification of the investment industry is well underway. A significant finding is that increased client sophistication will result in the industry pendulum swinging away from its current benchmark-centric orientation. Plan sponsors will continue to move away from traditional risk management constraints in favour of more sophisticated risk management approaches. This will provide investment managers with greater freedom in their pursuit of alpha but it will also confer greater responsibility on them. No longer will they be able to rely on traditional risk management constraints as a way of managing portfolio risk. Investment managers’ risk management skills will need to be elevated and it will continue to be a key strategic differentiator.