Let's assume we're all past the point of disputing the benefits of greater diversity within asset management. The tougher question we now face is, how do we make it happen? Indeed, given our industry's knack for expediency, increasing the share of assets under management by women-and-minority-owned firms will require a disruption — one that will force allocators to rethink their investment manager selection processes.
The reality is that typical investment manager selection practices have the effect of being biased, albeit unintentionally, against women- and minority-owned firms. Modifying these practices would not only improve diversity, but it would likely also improve investment performance.
To understand how these biases arise, we must first consider how allocators select investment managers. The process typically begins when an allocator is frustrated by the weak intermediate-term performance of an investment manager and asks its consultant to give it a list of replacement managers that will ostensibly perform better. After filtering out those firms with track records that are too short or below average, whose assets under management remain below a threshold and whose investment teams haven't worked together long enough, a handful of managers are suggested to the allocator. Sometimes the allocator supplements the consultant's work with suggestions, but more often than not the allocator simply requests that three or four managers appear at a finals presentation, where the managers pitch their capabilities. After the presentations, the allocator normally selects the manager with the best intermediate-term performance.
Obviously, there is a lot wrong with this type of selection process, and the problems go far beyond mere performance-chasing. Such processes are fraught with behavioral biases and have the effect of diverting allocators away from diverse firms, which tend to be newer and smaller than their peers. Indeed, according to self-reported data from eVestment, there is a meaningful difference in size and tenure between firms with and without significant women or minority ownership. Most firms do not even report on their minority ownership levels, but among firms that did as of June 30, those that reported greater than 50% women or minority ownership had a median AUM that was only 16% of the median AUM of firms with less than 50% women or minority ownership. Likewise, firms with greater minority ownership were founded on average nine years after those with less.
The use of criteria that happen to be skewed against diverse firms would be more understandable if it was shown to add value to allocators. After all, no fiduciary should allocate to a diverse firm simply to check a box. Considerable research suggests, however, that smaller (and presumably newer) firms tend to perform better than bigger ones in most asset classes. Accordingly, these widespread selection practices are not only biased, they are actually injurious to the allocator's own economic interests.
To see the shortcomings, allocators should look no further than the criteria used the next time a large public plan wants to hire a new small-cap investment manager. They'll likely see minimum requirements such as $2 billion of firmwide AUM, $500 million of product-level AUM and a GIPS-certified track record of at least five years. Once allocators overlay the inevitable strong recent performance required for inclusion, they have the perfect recipe to identify a manager that has benefited from recent stylistic tailwinds; has grown rapidly; and now manages enough capital in the selected strategy that their future return prospects are notably less than they have achieved historically.
Presumably, these criteria are used as convenient proxies to ensure the manager's financial health, its commitment to a product, the scalability of a particular strategy or the relevance of its historical performance. These are all legitimate concerns, but each of these issues would be more appropriately addressed through direct discussion and analysis.
For example, allocators could ditch arbitrary track record minimums and instead focus on questions that actually address the risks they're aiming to mitigate:
- Is the track record consistent with the investment philosophy and process?
- Does the track record cover enough market environments?
- How relevant is the track record based on people and process changes that have occurred at the firm?
Similarly, an allocator's insistence on certain size requirements is likely intended as a rough proxy of an investment manager's financial sustainability or ability to accommodate larger allocations. If an allocator were to ditch AUM thresholds altogether, it could evaluate the same risks by investigating whether a firm has necessary resources to effectively implement its investment strategy or by asking about a firm's financial runway or back-up resources should its revenues stagnate.
Finally, instead of lapsing into a simple construct of "more years of experience is good and fewer years of experience is bad," allocators should seek to understand the impact of experience on a particular manager's investment proposition. After all, many managers lose their edge over time due to factors such as the increased hubris and complacency that often accompany investment success and wealth, or simply the evolution in the roles of different team members. To bypass firm age or years of experience, allocators could more carefully consider the relevance of investment team members' prior experience, the changes in roles and responsibilities at the firm over time, and the motivation of the personnel.
Given that women-and-minority owned businesses tend to be newer and smaller, they will continue to be disadvantaged so long as allocators stick to crude rules of thumb to filter their opportunity set instead of thinking critically about which managers are most likely to produce the best results in the future. Real manager diversity will only occur when allocators employ more defensible criteria and demand the same from their consultants. In doing so, not only will the diversity of manager selection improve, but so will performance.
Paul Greenwood is the CEO and chief investment officer of Pacific Current Group in Tacoma, Wash. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.