Manager Selection and Due Diligence (CFA Level 1): Defining the Manager’s Role, Quantitative Screening, and Performance and Peer Comparisons. Key definitions, formulas, and exam tips.
Selecting the right manager (or multiple managers) for a portfolio isn’t just about picking the top performer on a league table. It involves thoroughly examining a potential manager’s investment style, track record, operational infrastructure, and even aspects like key personnel stability. And you won’t believe how often I’ve seen investors shortchange this process, only to wonder “What went wrong?” a few quarters down the road. Whether you’re looking for a dedicated equity manager with a small-cap focus or a bond manager specializing in high-yield securities, the due diligence process can be broken down into a few essential steps. Let’s walk through these steps and, in the process, make sure we don’t skip the finer (but critical) details.
Picking a manager starts with knowing precisely what role that manager is expected to play in your overall portfolio context. In Chapter 4 of this volume, we discussed how asset allocation is driven by the Investment Policy Statement (IPS). The IPS sets the overall risk and return objectives. Within that framework, you typically identify gaps or specialized needs—such as a strategic allocation to emerging market equity or a tactical allocation to high-yield bonds. That’s where manager selection comes in.
Core vs. Satellite. Often, folks like to differentiate between “core” managers (those who deliver broad market exposure with relatively stable performance) and “satellite” managers (those who employ specific, often higher-risk/higher-return strategies, like small-cap growth or frontier markets).
Specialty Mandates. Alternatively, think about real estate, private credit, or alternative strategies—maybe your portfolio needs these asset classes or sub-asset classes. Defining requirements upfront gives you a filter for the right manager universe to explore.
Risk Adjacencies. You want to ensure the manager’s strategy lines up with your portfolio’s risk budget (refer to Section 4.8, “Risk Budgeting in Portfolio Construction”) so that you don’t disrupt the overall volatility profile.
Once you’ve identified the universe of managers that fit your need, the next usual step is to comb through performance data. We all love a good scoreboard, but it’s not just about absolute returns. Think also about risk-adjusted metrics. For instance:
Evaluating performance relative to a “peer group” can also help highlight how the manager ranks among those pursuing similar mandates. At the same time, it can help you see if the manager stands out for good reasons—like consistent outperformance—or suspicious reasons—like outsized but unrepeatable bets.
Pay special attention to performance during stressed periods. Everyone looks like a genius in a bull market, but what about during the bear phases of the cycle? Seeing how the manager performed in 2008, 2020, and other crisis inflection points can reveal if their outperformance came from genuine skill, or if they just got lucky with certain positions.
Numbers only tell part of the story. A manager’s investment philosophy, as well as the processes that drive security selection and asset allocation, matter enormously.
Some managers are purely fundamental in nature—conducting in-depth research on each security—while others might rely heavily on quantitative signals. In real life, I once visited a manager with dusty shelves containing countless old-fashioned annual reports. It was almost comedic, but guess what? Their rigorous fundamental approach delivered consistent returns for over a decade.
You might discover that 90% of a firm’s strategy relies on the intellect of one star portfolio manager. If that person walks away tomorrow, the performance might walk away, too. That’s known as key person risk, and you want to know how the firm addresses it.
Look for stable organizational structures:
Additionally, you want to see how the manager has built out the rest of their team. An equity manager might highlight a team of data scientists, while a credit manager might have a robust research group scouring corporate issuers’ balance sheets.
How does the manager measure and manage risk? Do they have risk analytics platforms that provide real-time metrics? Do they use robust scenario analyses and stress tests (see Chapter 2.12, “Scenario and Sensitivity Analyses in Portfolio Return”)?
A robust risk management culture is generally a sign that the organization prioritizes consistent outcomes rather than “heroic” short-term spikes in performance.
Just like you wouldn’t board a car with faulty brakes, you don’t want to hire a manager that isn’t buttoned up on compliance or ethical practice. Operational due diligence might feel a bit mundane, but it’s absolutely core:
Many institutional investors have entire teams dedicated to verifying that a manager’s operational setup meets strict standards.
Sometimes managers get bored or tempted to chase the latest trends. Next thing you know, a “value” manager is buying up growth stocks. This phenomenon, known as style drift, can be detrimental if it conflicts with your asset allocation plan or reintroduces unintentional risk. Keep an eye on the manager’s exposures. Are they consistent with the stated mandate?
No one is perfect in finance—everyone stumbles. I recall once a manager highlighting a single rough year but explaining convincingly how certain macro factors caught them off guard. But they demonstrated how they adjusted their process to avoid repeating the same mistake. Conversely, some managers might rationalize major drawdowns with vague excuses, crossing their fingers you’ll look elsewhere.
Analyzing multi-year track records that encompass bull, bear, and sideways markets will give you a more accurate sense of how the process works. If you see consistent convictions and a methodical, disciplined approach to trades, that can be evidence of skill rather than luck.
High fees can eat into returns, particularly in a low-return environment. Fee structures usually come in two flavors:
When well-designed, performance-based fees can align manager incentives with investor outcomes. But be careful about structures that encourage excessive risk-taking (for instance, a manager might “swing for the fences” if they’re far below the performance hurdle).
Understanding the total cost—including possible hidden fees like distribution, trading costs, or administrative expenses—is key. Even small differences can add up if a manager is not transparent.
Selection isn’t a one-time process. Once the manager is in place, you want to specify formal monitoring procedures, including:
Remember, if you’re not periodically verifying that your manager is doing what they claimed they would do, you risk waking up later to discover they’ve veered away from your strategy or encountered undisclosed operational problems.
Below is a simple flow diagram illustrating how manager selection fits into the broader portfolio construction process:
flowchart LR
A["Define Manager Role <br/>(Strategy, Mandate)"] --> B["Quantitative Screening <br/>(Performance, Risk)"]
B --> C["Qualitative Assessment <br/>(Philosophy, Team)"]
C --> D["Operational Due Diligence <br/>(Compliance, Ethics)"]
D --> E["Final Selection & <br/>Ongoing Monitoring"]
This diagram underscores the iterative nature of manager selection. Even after finalizing a candidate, you revisit and monitor on an ongoing basis.
Imagine a small endowment looking to add a hedge-fund manager to provide an uncorrelated return stream. They define a role for a long-short equity manager who can potentially dampen portfolio volatility. After screening a dozen candidates for performance, they shortlist three.
– Manager A delivered strong returns, but a single portfolio manager is essentially calling all the shots. Key person risk is high.
– Manager B has moderate returns but minimal drawdowns, and a sizeable in-house research team. Low turnover among senior staff.
– Manager C shows extremely high returns relative to peers, but interview reveals they make leveraged bets, with uncertain risk controls.
After the quantitative look, they carry out a more thorough operational due diligence. Manager A actually had a regulatory fine a few years back (not a showstopper, but definitely requires extra caution). Manager B invests heavily in compliance systems and passes the due diligence check. Manager C’s staff is mostly new, and there’s a mystery around how the firm invests. Ultimately, the endowment concludes Manager B’s moderate but steady approach, combined with strong risk management, best fits the endowment’s overall risk tolerance and return objectives.
Manager selection and due diligence are core pillars of portfolio planning. In the CFA exam context, remember that you’ll often see scenario-based questions asking you to compare different managers, interpret performance track records, or assess how well a manager’s style suits a portfolio objective.
In your exam, if you’re faced with an item set about choosing a manager, look for details around risk control, team stability, alignment of incentives, and historical performance under varying markets. Structured answers that balance quantitative insights (e.g., Sharpe ratios, maximum drawdown) with qualitative analysis (e.g., firm stability, manager skill) will generally stand out.
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