Contrast Type I and Type Ii Errors in Manager Continuation Decisions

• Contrast investment manager selection to performance appraisal;

Performance appraisal is used to evaluate the investment performance of a fund or strategy in order to understand and assess the past decisions and abilities of an investment manager.

Manager selection involves using qualitative and quantitative methods to determine whether an investment manager displays skill and the likelihood that he or she will continue to display skill in the future.

• Describe how investment manager selection takes place in the context of the client's investment policy statement;

The investment policy statement (IPS) frames the manager selection process by capturing both investment information and investor constraints. Investor constraints can include risk tolerance, investment objectives, investment philosophy, liquidity preference, time horizon specifications, tax implications, regulatory issues, and any other unique circumstances that might need to be observed.

• Describe qualitative considerations in evaluating investment managers;

Qualitative considerations when evaluating investment managers involve determining whether or not an investment manager is expected to continue to add value. This is done as part of due diligence, which seeks to understand the philosophy and portfolio construction process of an investment manager in support of an investment action, decision, or recommendation.

• Compare the selection of active and passive investment managers;

The choice between active and passive investment managers is a function of the investor's assumptions about market efficiency, confidence in the ability to identify skilled investment managers, and the expectation that the investment manager can add value relative to the benchmark after fees and taxes in taxable portfolios. An investor would likely prefer passive management if he or she believes that a particular market is highly efficient.

Tracking risk is the standard deviation of active returns and can be used to measure how closely a portfolio's return approximates the returns on its benchmark. The lower the tracking error, the more closely the portfolio mimics its benchmark's performance.

Active share is another tool used to measure the difference in portfolio holds relative to the benchmark. An investment manager that replicates the benchmark will have an active share of zero while an investment manager with no holdings in common with the benchmark will have an active share of one.

• Describe the components of a manager selection process, including due diligence;

The manager selection process involves defining the universe, quantitative analysis, and qualitative analysis.

Investment due diligence is performed as part of either quantitative or qualitative analysis to determine which investment manager "best" fits the needs of a portfolio. Investment due diligence looks at things such as a firm's philosophy, process, people, and portfolio construction to ascertain whether past performance provides some guidance for expected future performance.

Operational due diligence is performed as part of qualitative analysis to determine whether the investment manager's track record is accurate and whether it fully reflects risks. It examines the structure of the firm to verify that it is operated as a successful business to ensure sustainability.

• Contrast Type I and Type II errors in manager hiring and continuation decisions;

Type I error –  Hiring or retaining an investment manager who subsequently underperforms expectations. Rejecting the null hypothesis of no skill when it is correct.

Type II error – Not hiring or firing a investment manager who subsequently outperforms, or performs in line with, expectations. Not rejecting the null hypothesis when it is incorrect.

• Type I errors are errors of commission, an active decision that turned out to be incorrect, whereas Type II errors are errors of omission, or inaction.
• Type I errors create explicit costs, whereas Type II errors create opportunity costs.
• Type I errors are relatively straightforward to measure, whereas Type II errors are unlikely to be measured.
• Type I errors are more transparent to investors, whereas Type II errors are less apparent to investors.

• Describe uses of style analysis in investment manager selection;

Style analysis relates to the understanding of an investment manager's risk exposures relative to the benchmark and how they evolve over time. In other words, style analysis gives investors an idea of the investment style of the securities within a portfolio. Style analysis can be evaluated using returns-based style analysis or holdings-based style analysis to determine the risks and sources of return for a particular strategy.

• Compare returns-based and holdings-based style analysis, including the advantages and disadvantages of each;

Returns-based style analysis is a top-down approach that estimates the sensitivities of a portfolio to security market indexes and identifies the important drivers of return and risk factors of a portfolio. This method is easy and straightforward to use because it utilizes readily available data. That being said, it can also be imprecise, especially if the securities within a portfolio are illiquid, non-traded, or have stale prices.

Holdings-based style analysis is a bottom-up approach that estimates the risk exposures from the actual securities held in a portfolio at a point in time. This method detects style drift faster and is comparable across managers and through time. That being said, given that the portfolio reflects a snapshot in time, it might not reflect a portfolio's future characteristics. In addition, as opposed to returns-based style analysis, holdings-based style analysis requires data which might not be easily obtainable.

• Describe uses of the upside capture ratio, downside capture ratio, maximum drawdown, drawdown duration, and up/down capture in evaluating managers;

Upside capture ratio – A measure of capture when the benchmark return is positive in a given period. An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns. The geometric average of the returns is used for periods greater than one year.

Downside capture ratio – A measure of capture when the benchmark return is negative in a given period. An downside capture ratio over 100 indicates a fund has generally underperformed the benchmark during periods of negative returns. The geometric average of the returns is used for periods greater than one year.

Maximum drawdown – The maximum loss (lowest cumulative return) achieved during the drawdown duration.

Drawdown duration – The total time from the start of a drawdown until the cumulative return of the drawdown recovers to zero. The drawdown duration can be segmented into the drawdown phase (start to trough) and recovery phase (trough to zero).

Capture ratio – A ratio which measures the asymmetry of returns. A capture ratio of greater than one indicates positive (convex) asymmetry, whereas a capture ratio of less than one indicates negative (concave) asymmetry.

• Describe uses of the "batting average" in evaluating managers;

Batting average is a measure of performance consistency. It measures the frequency of positive outcomes using either an absolute or relative method.

Absolute batting average includes all positive returns, whereas relative batting average only includes positive returns greater than the benchmark return.

A disadvantage of batting average is that it does not measure the magnitude of returns. Strategies with many small gains and the occasional large loss will have high batting averages, but the distribution of returns will be negatively skewed. This return distribution is less attractive to investors that want to limit large drawdowns.

• Evaluate a manager's investment philosophy and investment decision-making process;

An investment manager's investment philosophy is the foundation of the investment process. First, investment managers make assumptions about market efficiency. Those who believe the market is efficient will utilise passive strategies and seek to earn risk premiums. A risk premium is the return in excess of the risk-free rate that is expected by investors for bearing some sort of systematic (non-diversifiable) risk. Investment managers who believe the market is inefficient will utilise active strategies and seek to capture return through behavioural and/or structural inefficiencies. The former relates to perceived mispricings created by the actions of other market participants while the latter pertains to the perceived mispricings created by external or internal rules and regulations.

The investment decision-making process involves signal creation, signal capture, portfolio construction, and portfolio m onitoring. Signal creation is synonymous with idea generation. The key to exploiting market inefficiencies is to have information that is unique, timely, and interpreted differently. Signal capture is synonymous with idea implementation and translating investment ideas into investment positions. Portfolio construction dives into an investment manager's risk management methodology and portfolio monitoring assesses both external and internal considerations to ensure that the investment manager remains appropriate for a client's mandate.

• Compare the evaluation of pooled investment vehicles and separate accounts;

Compared to pooled (or commingled) vehicles, separate accounts offer additional control, customisation, tax efficiency, and reporting and transparency advantages, although generally at a higher cost. When performing operational due diligence, additional deliberation should be considered to take into account the customisable nature of separately managed accounts.

• Compare types of investment manager contracts, including their major provisions and advantages and disadvantages;

The prospectus, private placement memorandum, and/or limited partnership agreement are essentially contracts between the investor and the investment manager, outlining each party's rights and responsibilities. The provisions are liquidity terms and fees.

Limited liquidity terms reduce flexibility to adjust portfolio allocations in light of changing market conditions or investor circumstances, as well as the reduced ability to meet unexpected liquidity needs. The advantage is that it allows portfolios to take a long-term view and reduces the risk of having to divest assets during unfavourable market conditions in response to redemption requests.

A management fee lowers the level of realized return without affecting the standard deviation, whereas a performance fee has the added effect of lowering the realized standard deviation.

• Evaluate a manager's adherence to a stated investment philosophy and investment decision-making process;

Monitoring investment managers involves operational due diligence and should be done on a regular basis. Operational due diligence examines and evaluates a firm's policy and procedures to identify potential risks that might not be captured in historical performance. Simply relying on performance as a signal might not be timely or useful when deciding whether or not to retain an investment manager. Instead, poor performance should be utilized as a trigger to reevaluate an investment manager's adherence to philosophy and process and to assess a firm's sustainability.

• Define style drift and judge whether style drift has occurred;

Style drift is a deviation from the stated risk factor exposure outlined in an investment manager's philosophy and process and identified using returns-based and/or holdings-based style analysis. It is important to identify style drift because style drift undermines confidence in the repeatability of an investment process and may also suggest that an investment manager is no longer suitable for the strategy of a particular investor. Style drift is viewed as a relative concept and should be measured against an appropriate benchmark. Style drift can happen for a variety of reasons and evaluators must determine whether deviations represent a long- or short-term change in an investment manager's philosophy and process.

Style drift can be measured using asnail trail chart, whichdisplays information about the manager's return characteristics through time. A snail chart with data points on top of each other indicates consistent adherence to philosophy and process.

• Describe considerations in investment manager continuance;

Personnel continuity is a sign of stability and unexpected departures or high personnel turnover can distract individuals from focusing on the investment process and is likely to negatively affect performance.

Legal and compliance issues should be reviewed to confirm that a firm's interests remain aligned with those of the investor.

Monitoring growth in assets under management is also important because at times, style drift can occur as a result of an investment manager attempting to maintain performance or implement a strategy with a larger asset base. Closing a fund or strategy shows discipline and alignment of interests by the investment manager. A firm should have a clear policy and consistent process for closing funds. Two common methods of closing a fund are a hard close and a soft close. A hard close is when an investment manager closes the fund to all investors. A soft close is when an investment manager closes the fund to new investors but keeps it open to current investors.

Liquidity risk should also be considered, as there is a higher risk of a fund with a limited number of investors being negatively impacted by redemptions.

• Describe criteria for evaluating passive managers.

Passive investment managers should be evaluated based on their tracking tolerance, portfolio construction process, and operational efficiency.

Tracking tolerance is an investment manager's tracking risk target. If the investment manager is replicating an index, quantitative analysis should depict low tracking risk, low active share, zero alpha, and systematic risk exposures close to one.

Portfolio construction involves either full replication of an index or sampling.

Operational efficiency measures the investment manager's ability to trade at low cost with minimal cash.

Institute, CFA. 2016 CIPM Principles Curriculum. CFA Institute, 11/2015. VitalSource Bookshelf Online.

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