It is becoming increasingly difficult for both boutique and emerging institutional investment managers to differentiate themselves enough to raise meaningful assets. Moreover, the need for a three-year track record is a significant hurdle to overcome for a new business, and even with that in place there is no guarantee of success. It is ironic that the first disclaimer you are likely to come across in the investment business says that past performance is no indication of future results, yet so much emphasis is placed on track record! A good track record is a potentially useful signal, but it by no means tells the whole story.
It is becoming increasingly difficult for both boutique and emerging institutional investment managers to differentiate themselves enough to raise meaningful assets. Moreover, the need for a three-year track record is a significant hurdle to overcome for a new business, and even with that in place there is no guarantee of success. It is ironic that the first disclaimer you are likely to come across in the investment business says that past performance is no indication of future results, yet so much emphasis is placed on track record! A good track record is a potentially useful signal, but it by no means tells the whole story.
On the other side of the fence, investment allocators often face an adverse selection problem when it comes to choosing managers and strategies to allocate to. There are inherent information asymmetries because of the lack of transparency that is generally offered regarding how an investment strategy is designed and managed. Investment managers, and especially hedge-funds, are highly sensitive to being fully transparent primarily based on the concern that it could compromise their intellectual property. While some of those concerns are warranted, they can easily be addressed in a way that provides allocators transparency without compromising any trade secrets.
At a high level, evaluating manager skill boils down to understanding how many independent bets they make, how often those bets are made and how they are sized. A great track record that is explained by an outsized bet in a single name is unlikely to be a good basis for future success. Allowing allocators unfettered access to historical daily holdings is what is required to make a fair and informed judgement regarding manager skill. Obviously very recent holdings can remain private due to the risk of front running, and the size of that lag should be a function of the strategy speed and turnover.
Regardless of how skillful a manager may be, every portfolio is likely to tell a good, bad, and sometimes ugly story at some point in its history. Portfolio managers and quantitative researchers are as fallible as the rest of us, and with the benefit of hindsight, mistakes are easy to see. What is important is not that past mistakes were made, but what lessons were learned and how are those lessons reflected in the investment process going forward. Owning up to past errors and being able to articulate what improvements have been affected as a result builds genuine trust. It is a basis to form unparalleled long-term partnerships.
Having the courage to be fully transparent by providing allocators with historical daily holdings is an unquestionable sign of quality. It signals a manager’s faith in their investment process, the humility to admit past mistakes openly, and demonstrates the wisdom that comes from those difficult lessons. It also helps focus the conversation on process over outcome, and perhaps down weights the emphasis on track record alone. At the very least, it reveals whether that track record is more than just a mirage.
Smaller boutique and emerging managers have an opportunity to be leaders in offering allocators full transparency, with the potential to build unparalleled long-term partnerships with their clients. It is an approach that will likely boost a manager’s ability to raise assets, and make those assets much stickier, while providing allocators with transparency and the scope for customization they so highly value. A clear win-win.
The D3X QuantHub platform has been designed to offer investment managers and allocators a unique collaborative environment that provides unprecedented transparency as well as the ability to customize existing strategies to better address the needs of a mandate. To find out more, request a demo at the link below.
