The process goes far beyond simply evaluating past returns.

Investment management is a crucial component in achieving long-term financial goals. However, most investors do not directly hold securities but instead rely on intermediaries, such as pooled investment vehicles (e.g., unit trust funds, hedge funds, private equity funds, or exchange-traded funds) or separately managed accounts. These intermediaries entrust the services of professional investment managers who work to help investors meet their objectives.

Selecting an appropriate investment manager is critical. This process goes far beyond simply evaluating past returns. It involves aligning the manager’s expertise with the investor’s specific needs.

This article will delve into how investment manager selection takes place in the context of an investor’s personal needs and the factors that advisors and investors should consider during this process.

The role of investment managers

Investment managers serve as intermediaries for investors who typically do not manage their own portfolios. Whether the manager operates within a hedge fund, private equity firm, or unit trust, their primary role is to make informed investment decisions on behalf of their clients to meet specified objectives. The selection of the right manager, therefore, has significant financial consequences, as it can impact the portfolio’s ability to reach desired outcomes.

However, selecting a manager is not a one-size-fits-all exercise. Investors have varying assumptions, preferences, and biases regarding their investments. These individual factors must be thoroughly evaluated before making a decision.

A key part of this evaluation is understanding the investor’s liquidity needs, time horizon, tax considerations, legal factors, and any unique circumstances, such as environmental, social, and governance (ESG) preferences. Once these elements are understood, the universe of managers can be narrowed down to those who are best suited to meet these criteria.

Determining the right benchmark

A crucial first step in selecting a manager is establishing an appropriate benchmark for comparison. The benchmark is typically aligned with the investor’s asset allocation – whether equities, fixed income, or other asset classes – and serves as a reference point for the investor’s return requirements and risk tolerance.

Advisors begin the process by understanding the client’s needs, which guide the selection criteria for potential managers. The goal is not simply to identify managers with the highest returns but to find those whose investment strategies align with the investor’s objectives, timeframe, and risk tolerance.

For instance, an investor looking for exposure to equity markets will require a manager who understands the dynamics of equities, but also one whose risk profile and investment philosophy match the client’s objectives. A manager with expertise in fixed income may not be appropriate for an investor seeking aggressive growth through equities.

Liquidity, time horizon, and tax considerations

Liquidity needs and time horizons are fundamental factors in deciding the appropriate type of investment manager. Investors who need regular access to their funds, for example, may benefit from a manager who specialises in more liquid assets. Conversely, investors with a longer time horizon may favour managers who can invest in less liquid, higher return-generating opportunities such as private equity or long-term bonds. Tax considerations also play a role, as different types of investment vehicles come with varying tax treatments.

Active vs passive management

One key decision investors and advisors must make is between active and passive management. Active managers seek to outperform a given benchmark by employing strategies to identify and exploit market inefficiencies. On the other hand, passive managers aim to replicate the performance of a market index with minimal costs.

The choice between these two strategies is influenced by the investor’s outlook on market efficiency and the level of risk they are willing to assume. Those who believe that markets are generally efficient may opt for a passive strategy, focusing on cost efficiency and broad market exposure. Conversely, investors who believe that markets are inefficient and can be exploited may choose active managers who aim to generate alpha by outperforming the market.

Evaluating the manager’s suitability

Once a suitable benchmark is identified, advisors need to assess the managers based on their investment philosophy and ability to fit the investor’s needs. This evaluation goes beyond just historical performance. The manager’s investment process, risk management strategies, and consistency in executing their stated investment philosophy should be scrutinised.

Key areas to evaluate include:

  • Investment philosophy: Does the manager have a clear, articulated strategy that aligns with the investor’s objectives? A manager’s philosophy should be stable over time and based on credible assumptions about market behaviour.
  • Risk management: Can the manager effectively balance risk and reward? An investor’s risk tolerance must be matched with a manager who understands how to control risks in varying market conditions.
  • Portfolio structure: Does the manager’s portfolio construction reflect the investor’s goals? A diversified portfolio that considers both asset class and risk factor exposures is critical.

These evaluations aim to ensure that the manager can provide consistent, long-term value aligned with the investor’s objectives.

Conclusion

Selecting the right investment manager is a complex, multifaceted process that should be driven by the investor’s unique needs.

Advisors play a critical role in ensuring that the manager’s expertise and strategies align with the investor’s liquidity requirements, time horizon, and risk profile. This alignment goes beyond merely seeking the highest returns, instead focusing on consistency, risk management, and an investment philosophy that fits the investor’s long-term goals.

Next week: I will discuss the ongoing process of evaluating and monitoring managers to ensure they remain a good fit for the investor’s portfolio. Moreover, I will explore due diligence practices, which are crucial to safeguarding the investor’s interests and identifying potential risks.