The “Usual” Fund Selection Process
Any allocator or fund selector has to deal with thousands of requests per year from both emerging and large fund managers for allocations in their fund selection process. This process is a long-term one, and managers come in different varieties. Fund selection criteria must be rigorous to vet mediocre managers, but flexible enough as not to cut high-potential managers.
Among the different trends and demands from allocators, there are interesting criteria to keep in mind when vetting managers of money.
Things to look for that are hallmarks of a great manager:
- Clarity of investment process articulation;
- Transparency and raw numbers (Providing quarterly, third-party audited numbers and being fully transparent about worse periods);
- Education and balance (Managers that have the capability to tailor their presentation for private and institutional clients, focusing on educating the former about complex strategies and assets and focusing on providing detail to the latter);
There are also some things to be aware of when vetting different managers:
- Hedging against charisma and personality types (especially for emerging managers with no record of performance);
- Disconnect from allocator/board/committee peer pressure (invest in a manager because you genuinely want to, and not because of what fellow allocators or your investment board/committee think);
- Going beyond the DDQs (going deeper in due diligence with custom, laser-focused questions to really put managers to the test);
- Separate the yes/no from the when (just because you decide to invest in a manager, it doesn’t mean it has to be now, and/or just because you can’t invest now it doesn’t mean you can’t invest);
Articulation of the Investment Process
Most allocators consider the quality of a manager’s investment process to be represented by their capacity to articulate. While this is not necessarily true, it’s a good indicator of how their mind works and what their processes are.
Transparency and Director’s Cut
With the latest frauds and instability, allocators nowadays are moving towards liquidity and transparency. While liquidity is not available for all strategies and all managers, transparency is something to be demanded of managers.
Excellent managers of money will not only provide periodic, third-party audited numbers of performance, but they will already come into the meeting with them prepared.
Excellent managers will also provide “unedited” numbers, including down months, mediocre months or other periods without hiding or embellishing the numbers. Be careful of managers that seem “too good to be true” or that are not honest about worse periods. Seek transparency, not perfection.
Seek Educators and Balancers
If you are an institutional allocator, you will probably be familiar with all of the asset classes and investment methodologies the manager will present you. They’re part of the usual fund selection criteria. Great managers can tailor the level of depth of their presentation to educate private investors, not drowning them with details, and to provide the necessary level of detail to institutional allocators, being able to answer deeper, more targeted questions.
If you’re a private educator, pay attention to whether the manager is taking enough care to educate you on their investment process and asset classes; if you’re an institutional investor, check whether their presentation gives you enough level of detail into the process and asset strategies.
Hedging Against Manager Charisma
Analog to the startup founder charisma, which blinds investors from data due to the personal magnetism of the founder, this also happens in the fund selection process in terms of the charisma of money managers – especially in emerging fund managers, when quarterly audited performance reports are not available and allocators invest based on the manager’s potential for success (side note: especially if they’ve been coached by me to assess your personality time and use it to maximize the message)
It’s important to recognize the potential of managers and money, but not be blind to the quality of the investment process and operational quality due to this. Liking a manager does not equate making a good investment. It’s important to value a manager’s charisma, but separate good charisma from a good investment.
Disconnect from Allocator/Board/Committee Peer Pressure
It’s no news that many times an allocator invests – or fails to – because of the opinion of fellow allocators about a specific manager. It’s important, as an allocator, to think by yourself and have the courage to be contrarian when you don’t agree with others in terms of the fund selection criteria / actual decision.
There is usually no divergence of opinion when a manager fulfills all requirements. This kind of situation usually happens when, for example, a great manager has a couple of down months, or has lost a key person, or has a small flaw in otherwise institutional-quality operational processes, that is just enough to take them off the top tier list but still be considered as someone with great potential. This is where the rubber meets the road. What if other five allocators of the same type as you do not want to invest in this manager but you do?
The same goes for your investment board/committee. It’s possible they will want to pressure you to invest in a manager when you really don’t want to, or vice-versa. Don’t let peer pressure force you into making a mistake.
The goal here is not to be contrarian for the sake of being contrarian. But when peer pressure is forcing you to stay out when you think the manager has potential – or the precise opposite – have the courage to make your own decision apart from other allocators’ opinions.
Going Beyond the DDQs
The standardization of DDQ templates provides for a high level of convenience in due diligence, but if a prospective fund selector or allocator does not go beyond them, they risk not getting the full picture of a fund’s performance.
While the DDQ will tell you facts and numbers, it’s important to look the manager in the eyes and confront them about their decisions and history from a personal point of view. What led to this down month that is not in the books? What was the cause of a key person leaving? Prepared answers and numbers may seem strong on paper, but the manager may crumble in a real-world cross-examination. Make sure prospective allocation receivers have good answers at this stage.
Separate the “Yes/No” from the “When”
There are times when you can’t currently invest in a manager – either because of restrictions on your side (lack of liquid funds to invest) or theirs (not fully invested yet, or overcommitted at the moment). Several aspects – including peer pressure from fellow allocators, your investment committee or your board – will tell a prospective allocator not to invest.
But, as with many things in life, it’s important to separate a “no” from a “not yet”. Or a “yes” from a “yes right now”. You will have both cases where you cannot invest at the moment, but you want to keep the manager in mind for the future, or when you do want to invest in the manager, but it’s not the right moment.
You will be pressured to make a move right away. Resist that pressure.
Conclusion: The Hidden Fund Selection Criteria
While many allocators are used to the usual fund selection criteria, there are additional things to keep in mind – many of them counterintuitive – that will help you be a better vetter of money managers. For you sake and your stakeholders’.