Past returns may have little influence on how successful allocators choose managers, one study has suggested.
Endowments, funds-of-funds, pension funds, and other allocators tend to rely heavily on “soft” information—manager characteristics conveyed via in-person meetings and private research—rather than data, according to researchers from the University of North Carolina and Tulane University.
This soft information, intended to help decision-makers determine an investment’s potential quality, can include a manager’s style, idea generation process, risk management strategy, and organization structure.
Such information “strongly influences” manager selection decisions—and helps ensure allocators make the right ones, according to study authors Gregory Brown, Oleg Gredil, and Preetesh Kantak.
“Both the level and uncertainty of soft information are strong predictors of the probability of selecting a fund,” they wrote. “These recommendations add pecuniary value to the allocator.”
The case study delved into a $15 billion-plus institutional investors’ due diligence in allocating to long-short equity hedge funds over a seven-year period.
When the investor selected funds based on soft information, these picks outperformed rejected managers by 1.5% over the next year.
“We find no evidence that relying on soft information, which is potentially prone to poor subjective judgments, degrades the allocator’s performance,” the researchers continued.
But this alpha faded away roughly a year into the relationship, highlighting the importance of moving efficiently in manager selection. Using soft information can be an inherently protracted process, Brown, Gredil, and Kantak acknowledged. While of better quality, is it more expensive and time-consuming to obtain than publicly available “hard” information.
“The investor’s problem can be framed as a tension between acting quickly using widely available ‘hard information’ that is fairly cheap to obtain but of relatively low quality versus expending resources (time, labor, and fees) to obtain additional ‘soft information’ that will better allow the allocator to identify the quality of the fund manager,” they concluded.
Read the full report, “Finding Fortune: How Do Institutional Investors Pick Asset Managers?”