Assessing manager selection skill can quickly boil down to assessment of minutiae: a few basis points of alpha here and a stylistic nuance there but while all outperformance is welcome, one of the key roles of manager selection is downside protection. 
There are numerous ways that investors can lose money. Some investing risks are inherent, such as having to convert a paper loss into an actual loss because you have to liquidate a holding that is underwater and would likely recover if given time. There are many other permanent ways to lose client money. These are often a result of careless strategy selection rather than market characteristics.
The irony is that there is no track record we can point to that overtly shows the impact of avoiding stumbles. Rather the absence of such potential drag on return is only evident from the good long-term returns delivered to clients which would be lower had there been greater impairment of capital.
There are a number of different types of potential mishaps that exist for the unwitting, but generally they fit into one of three broad categories.
The first are liquidity mismatches.
Many daily dealing funds buy illiquid assets within them. This is a clear risk that is manageable in normal times but if there is a rush for the door, these funds turn into lobster pots – very easy to get into but devilishly difficult (and all too often impossible) to exit when you want to. If these strategies become forced sellers, investor losses can accumulate rapidly. Worse still, they may be ‘gated’ and it could be months before you get your money back (at a likely discount). This is a topical matter presently but even when it is far from the headlines it should not be far from the forefront of a manager selector’s mind.
The second are naïve investment theses.
Many sound good on paper but even the most level headed back tests are the product of hindsight which may not fit the future as well as the past. Hedges are often imperfect; long term relationships can break down sporadically and ultimately there have been many smart investors undone by a heady mix of overconfidence and the perniciousness of markets. The usual suspects that can lead to a strategy coming unstuck include leverage, poor risk controls, mark to model, regulatory or tax changes and so on. Marked to model performance is, in most cases, undertaken with genuine professionalism and diligence. It is worth bearing in mind, however, that it is essentially an elegant way of saying that the price is made up. Not plucked from thin air but based on comparison to similar deals elsewhere or other metrics, but it is not a price that it is possible to trade at on a moment’s notice. The problem with mark to model at times of market stress, is that you are unlikely to be the only seller and as a result, realised prices can quickly deviate from those on paper. On balance it may be preferable to take the day to day volatility from listed (largely attainable) market prices than have a gentler ride when the going is good, only to get a nasty shock when things get choppy.
The third is malign intent.
Rarely is this blatantly obvious, of course, but there have been a number of instances where we have recommended our investors steer clear of strategies that didn’t ‘smell right’. If something appears too good to be true, or too mind-bendingly difficult to comprehend, or so opaque that it is difficult to fathom, we tend to walk away.
These three main issues (and derivatives of them) become easier to identify with experience.
When doing fund research there is rarely a ‘daft’ question and often managers that are scornful in answering are trying to deflect. More often than not they are deflecting from their discomfort at the question, but it could be outright distraction. That is also why we endeavour to send a number of analysts to meet a fund that we are serious about investing in. Two heads are better than one and a few perspectives tend to be best at triangulating problems.
Additionally, it is imperative to have an independent operational due diligence team who assess, in parallel with the investment due diligence process, the appropriateness of all administrative and non-investment related due diligence matters. This is a useful risk reduction tool as it provides an objective assessment of the operational risks of a fund without being impacted by our analysts’ views on the investment merit of a holding.
No process is infallible but there can be no doubt that very detailed research, being savvy and unafraid to ask questions will one day prevent a costly mistake. While far less glamourous than stellar gains, avoiding permanent losses is actually very rewarding indeed.
James Klempster is director of investment management at Momentum Global Investment Management. The views expressed above are his own and should not be taken as investment advice.