The Paradox of Manager Selection Practices in a Changed World

A report from McKinsey included this eye-opening exhibit:

Setting aside questions about the specific calculations used (which are not included in the report), the exhibit illustrates the reality that a lot of money is spent on active strategies but not much alpha is generated.  That fact ought to prompt deep discussions about beliefs, resources, methods, and outcomes among the governing body, staff members, and external advisors of your organization.

An evergreen problem is that alpha is elusive, requiring allocators to adapt over time, yet due diligence and manager selection axioms and activities can easily ossify, becoming obsolete as conditions change.

In that regard, a paper, “Manager Selection & The Paradox of Skill,” from Dan O’Donnell of Acervus Securities (an affiliate of Addepar) is worth your attention.  It focuses specifically on private market investments.

Changing conditions

In the introduction, O’Donnell writes, “Unfortunately for allocators, the process by which investors source, screen and select managers is growing increasingly complex.”  There has been “explosive growth in firm and fund formation” as investors have flocked to alternative strategies.  Coupled with that has been an increase in the expertise and experience of those involved, resulting in “the paradox of skill,” where “the dispersion of relative skill narrows” even as the “the absolute level of skill among practitioners” improves.

O’Donnell’s stated goal is “to improve allocators’ odds of successful manager selection by explicitly accounting for the paradox of skill in investment analysis.”  Because of assumed persistence in performance among the better fund firms, the go-to heuristic has been to invest only with ones that have delivered top-tier funds.  To question that premise, O’Donnell cites an article by Robert Harris, et. al, that asks, “Has persistence persisted?”

Helpful exhibits in O’Donnell’s paper illustrate that the answer is “no.”  The traditional measure of persistence — fund-to-fund performance — has declined over time, slightly for venture capital and much more for buyout funds.

A different metric, “investable persistence,” is calculated using “the returns presented for Fund N when investors must make a go or no-go decision on Fund N+1.”  Using that approach — a more realistic gauge of the circumstances under which decisions are made — the chance that a top-quartile fund will repeat that feat is no better than that of the overall population of funds.

O’Donnell:

In summary, the current conventional wisdom around manager selection was largely built upon a methodology that is not actually investable.

So a rethink is in order, especially given the conditions today.  The universe of players has exploded, with big increases in the number of asset owner organizations, allocators, and fund managers (and in the amount of invested assets) dedicated to private strategies.  And the bedrock of the selection process, chasing the best managers, no longer provides the foundation that it did, given that the paradox of skill appears to have entered the picture, just as it has in other areas of investment practice.  And to further disrupt the established order:

Complicating the matter is that very few, if any, of the investors leading firms today have practical experience with the current macroeconomic landscape — in particular, the one-two punch of rising interest rates and an inflationary environment.

Decision frameworks

The last part of the paper highlights three areas that O’Donnell stresses are needed in order to improve manager selection processes.  They aren’t revolutionary or controversial, and so wouldn’t prompt much debate on their own, but the important question is whether they are stated beliefs or lived ones.  To what extent have they formed the essence of due diligence and manager selection practices?

For each, O’Donnell offers a “foundational first principle,” some examples of how it comes into play, and a series of great due diligence questions.

Market inefficiency

The principle:  “Alternative investments exist to general alpha.”  Pretty straightforward, but the implications are profound.  Given today’s environment, how likely is it that the managers of popular strategies will be able to find mispriced assets?

Given the fee load of private market funds, managers who are not consistently uncovering mispriced assets are more likely a very expensive source of beta rather than alpha.

Does your approach assume that investments in alternatives with previously successful managers will repeat their success, or are you continually trying to put yourself in “an alpha-rich sweet spot,” with “inefficient price discovery at entry and efficient price discovery at exit”?

Edge resilience

The overriding principle here is that “markets are only growing more competitive and complex.”  If that’s the case, then maintaining a profitable edge is very difficult, so:

Allocators looking for resilient edges should seek out managers with a history of adapting quickly and fighting process inertia, even (or especially) where they are finding success.

Now, think about how drastically that recommendation contrasts with existing practice.  The allocator mantra of looking for a “consistent and repeatable process” indicates a clutching of process inertia, not an understanding of the dangers of doing so.

Holistic alignment

“Perfect alignment of LP and GP interests is the holy grail of investment governance.”  Although “perfection” is an unattainable standard, many of the relationships today don’t come within sight of it — and the parties involved don’t really try to get there.  Fund managers have long had the upper hand (especially if they are in that special quartile where persistence is said to exist), but that needs to change:

With an overabundance of options, investors should not need to compromise on economic or governance terms that are not LP-friendly.

And allocators need to have greater transparency into the organizations behind the funds, to see whether the unstated partnership terms — the way in which the fund sponsor is expected to behave and develop as a firm — are as mutually beneficial as those in the signed documents should be.

Track records

It will be difficult to break the cycle of having track records frame the decision process, even though they serve as a cracked lens through which potential opportunities are viewed.

For example, the paper includes this statement:

The data shows us that screening for strong track records is necessary, but no longer sufficient, to consistently select outperformers.

It may be necessary to observe and evaluate the track records of managers to be considered, but screening for strong ones should not be a step in the evaluation process, even if that makes for more work (and more challenging communication with those on governing bodies who have thrived in the old paradigm and want to feel like they are investing with top-quartile managers).

The greatest opportunities are for those who don’t anchor on past numbers but select managers based upon characteristics like those that O’Donnell has examined.