Manager selection is important for institutional investors. This refers to the professional expertise offered by investment consulting firms to select portfolio managers who can optimally manage assets for the institutional investors. We believe that manager selection plays an important role for individual investors as well.
Manager selectionPlan sponsors typically hire investment consulting firms to help them select portfolio managers. Suppose a pension fund (plan sponsor) has to invest USD 50 billion in various asset classes including equity and bonds. Further suppose that the pension fund proposes to invest USD 15 billion in equity, spread across three investment styles - large-cap value, mid-cap growth and small-cap blend. The investment consulting firm`s mandate would be to select portfolio managers in each style universe.
Suffice it to know that the process is very rigorous. It involves three-steps - performance measurement, performance attribution and performance appraisal. Take the large-cap value universe. The investment consulting firm will first measure the performance of all large-cap value managers. Next, the firm will compare each manager`s performance with the large-cap value index.
Manager selectionPlan sponsors typically hire investment consulting firms to help them select portfolio managers. Suppose a pension fund (plan sponsor) has to invest USD 50 billion in various asset classes including equity and bonds. Further suppose that the pension fund proposes to invest USD 15 billion in equity, spread across three investment styles - large-cap value, mid-cap growth and small-cap blend. The investment consulting firm`s mandate would be to select portfolio managers in each style universe.
Suffice it to know that the process is very rigorous. It involves three-steps - performance measurement, performance attribution and performance appraisal. Take the large-cap value universe. The investment consulting firm will first measure the performance of all large-cap value managers. Next, the firm will compare each manager`s performance with the large-cap value index.
The performance attribution analysis helps in explaining the factors that helped the portfolio managers generate returns in excess of the benchmark index. Suppose a large-cap value manager generated 16% return while the large-cap value index generated only 10%. The consulting firm will seek reasons as to how the portfolio manager was able to generate the excess return.
Finally, performance appraisal refers to a process where the consulting firm asks the question: Was the excess return due to luck or skill? Can the portfolio manager generate excess returns in the future as well? If the answer is in the affirmative, the investment consulting firm will recommend that the pension fund invest in the portfolio manager.
The question is: How is this three-step process relevant to individual investors?
Fund selection
Consider an individual investor who wants to take exposure to mid-cap stocks. She has a suite of funds to select from, thanks to the proliferation of funds and fund complexes in the country. The problem is more severe when an individual investor wants to buy diversified funds. How should an investor choose such a fund?
Individuals typically use personal finance Web sites that ranks funds according to their past performance; investors tend to select a fund that has been a top-performer in the last three years and five years.
The point is that past is not an indicator for the future. This does not mean past performance is not a useful measure to forecast future alpha. But buying a fund based only on its past performance may not always help the investor; for the fund may just as well perform poorly in the future.
Consider the evidence. The top-performing diversified fund over a five-year period lagged the leaders in its peer universe over a ten-year period. The phenomenon is no different for funds in other style universe such as mid-caps.
This is not all. The top-performing diversified fund over a five-year period returned 28% while the bottom in the list returned 0.50%; even the Nifty index returned 20% during the same period. This suggests that a wrong selection of fund could lead to negative alpha returns. Both these factors suggest that fund selection goes beyond mere ranking of fund returns.
Conclusion
Individual investors should strive to reduce the error of choosing an active manager who has generated excess returns through luck; for luck could well run out in the future. This is possible if investors engage in manager selection as institutional investors do. Such a process would increase the possibility of the investors achieving their stated investment objectives, through optimal passive and active exposure.
Finally, performance appraisal refers to a process where the consulting firm asks the question: Was the excess return due to luck or skill? Can the portfolio manager generate excess returns in the future as well? If the answer is in the affirmative, the investment consulting firm will recommend that the pension fund invest in the portfolio manager.
The question is: How is this three-step process relevant to individual investors?
Fund selection
Consider an individual investor who wants to take exposure to mid-cap stocks. She has a suite of funds to select from, thanks to the proliferation of funds and fund complexes in the country. The problem is more severe when an individual investor wants to buy diversified funds. How should an investor choose such a fund?
Individuals typically use personal finance Web sites that ranks funds according to their past performance; investors tend to select a fund that has been a top-performer in the last three years and five years.
The point is that past is not an indicator for the future. This does not mean past performance is not a useful measure to forecast future alpha. But buying a fund based only on its past performance may not always help the investor; for the fund may just as well perform poorly in the future.
Consider the evidence. The top-performing diversified fund over a five-year period lagged the leaders in its peer universe over a ten-year period. The phenomenon is no different for funds in other style universe such as mid-caps.
This is not all. The top-performing diversified fund over a five-year period returned 28% while the bottom in the list returned 0.50%; even the Nifty index returned 20% during the same period. This suggests that a wrong selection of fund could lead to negative alpha returns. Both these factors suggest that fund selection goes beyond mere ranking of fund returns.
Conclusion
Individual investors should strive to reduce the error of choosing an active manager who has generated excess returns through luck; for luck could well run out in the future. This is possible if investors engage in manager selection as institutional investors do. Such a process would increase the possibility of the investors achieving their stated investment objectives, through optimal passive and active exposure.
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