Understanding performance in asset management goes beyond the superficial analysis of past returns. In an industry where the past is often seen as a predictor of future success (paradoxically and consistently countered by fund managers themselves in fine print), a deeper dive into what constitutes "good performance" is essential not only for managers looking to properly demonstrate their effectiveness, but also for allocators who need to understand where their money is going.
For investment managers, revealing the strategy behind their success can be as challenging as the investment process itself.
While those who allocate assets have become better at evaluating what makes a solid asset management firm, many managers still struggle to communicate their strategies in an effective manner. It's one thing to work tirelessly on improving performance; it's another to explain the intricacies of that process in a way that's both clear and engaging.
A recalibration of the traditional benchmarks of performance evaluation is essential as the first step to navigating this issue. Performance as a concept transcends a portfolio manager’s mere numerical achievements throughout the years. Instead, it should be understood as a reflection of a manager's proficiency in identifying and exploiting market inefficiencies. For instance, a 12% return might seem impressive at first glance, but its value can only be judged against the manager’s opportunity set at the time.
Active hedge fund strategies should revolve around market inefficiencies to be exploited. If, for example, the return expectation of an opportunity set is 10 percent and a manager produces a 12 percent return, that manager obviously did a great job of maximizing the opportunity at hand. If, however, the opportunity set has a 25 percent return expectation and, once again, the manager produces 12 percent, then the manager did not do his or her job very well.
While both examples produced the same outcome, savvy allocators will understand why and how those returns came about. These allocators and the managers they work with usually both understand that if one places money with an active manager with a specific strategy, they are not necessarily in competition with the S&P 500. However, investors who cannot assess the why and how of that return are not analyzing performance correctly. At that point, they are simply guessing.
With the market always on the move, the goalposts for what constitutes good performance shift as well.
Manager evaluation relative to a given opportunity set seems simple in principle. But what happens when that opportunity set diminishes? How does an allocator know when a return expectation has gone from say, 25 percent, to 10 percent or 0 percent? That's a very reasonable question to ask. Should expectations fall, one would expect diminished performance for managers who are trying to extract that opportunity set. And while no one can positively predict the future, the expectations become clearer if one knows the opportunity set, the definitions, and the market participants.
History tells us what to look for when using data, analytics, and technology: market participants, available opportunities, dispersion, volatility and trends. Allocators and managers alike must undertake substantial research to understand this, and many of the larger players who have built great businesses do exactly that. However, many managers and allocators don't have the resources or analytics at their disposal every day to say, "This opportunity is finished."
This leads to managers and allocators seeking a more efficient way of understanding opportunity sets in the market and how to allocate capital directly operating within the internal capacities of their respective organizations. Large multi-strategy firms have benefited from the allocators’ understanding of this problem. Managers who can solve this problem – delivering targeted, differentiated return streams in a transparent manner while stripping overlapping fees – can be among the long-term winners in the industry.
As the industry evolves, the focus is increasingly on managers who can offer clear, distinct strategies without unnecessary fees or complexity.
The challenge for managers is to demystify their strategies, making them accessible and understandable to investors. This means breaking down complex investment decisions into comprehensible insights that highlight their value-add in any market condition.
If successful, these managers can move beyond the usual metrics and charts to effectively highlight their distinctive strategies, increasing their allure to investors in the process.
