How to Evaluate your Investment Managers

Investors should ensure that those who manage their assets must have sound processes and investment controls.

Thursday, March 17, 2011

Summary of Fitch's special report "Know Your Manager: Investor's Guide to Identifying a Robust Investment Process.

Current level of macroeconomic uncertainty and market volatility has increased the need for investment processes and stronger controls for asset managers as well as a clear understanding of these processes by the investor.

As a result of the crisis, institutional investors have lost several of their references as asset managers which were once successful and the processes used by these administrators have shown weaker performance, for example revealing hidden betas at the expense of alpha. Moreover, changes in organizational trends (such as centralized structures, decentralized, such as "boutique" or core / satellite) and the failure of many of these approaches have reduced the ability of investors to identify clearly the structure of a good investment process.

This report explains in detail the approach by Fitch Ratings on how to evaluate asset managers (see "Reviewing and Rating Asset Managers", August 2010), focusing particularly on the analysis of the investment process, which in turn is a fundamental part of Fitch's revision of asset management practices. Although this assessment is qualitative, the agency has led to "practical / solid references" to help identify the strengths and weaknesses of the investment process. Evaluation factors used by Fitch to analyze the investment processes are derived largely from considerations detailed on this report.

The most important aspects highlighted in this report are:
• The limitations of purely quantitative approach for selecting asset managers stressed the importance of careful analysis by institutional investors (pension funds, insurance companies, private banks) of the investment process of an asset manager, in terms of 1) a clear mandate and investment philosophy, 2) the adequacy of resources for research, 3) the strength of the investment decision making, and 4) discipline in the processes of construction and monitoring.
• Fitch identifies "sound practices" and makes key questions to be answered in four main areas of the investment process described above.
• The scope of the strategy (ie, the ability to diversify sources) is essential, as is the need for asset managers to display a competitive advantage in collecting and / or use of information.
• There is a bias / bias inherent in the process of making investment decisions, which includes a cognitive bias, such as over-confidence and collective thinking. Therefore, the structures and processes which encourage the "challenge mechanisms" (ie, compensatory or opposing forces) are particularly important. Fitch provides a list of potential prevention against these types of bias in decision-making.
• Sound methods of portfolio creation including monitoring as a "learning process" dynamic that is reused in the investment process.
• We discuss qualitative and quantitative considerations in the analysis of the investment process, referring to academic studies relevant in the context of the rating process of asset managers (M scale) by Fitch. The latter is designed to study the operational and structural risks of an asset manager in five areas, including investment process and portfolio management.

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