Emerging and Diverse Investment Manager Program Construction and Scaling

Abstract

This paper describes a process for creating a portfolio of diverse-owned and/or -managed investment strategies that is expected to generate both good performance and direct impact.

Structure and performance: We start with an adjustable combination of diverse index fund(s) and active emerging (newer/smaller AUM) strategies, an adjustable percentage of the latter being diverse-owned and/or -managed (where the definition of “diverse” is also customizable).

All of the active strategies rate sufficiently well under a manager research process that is designed or adjusted to avoid seeking “credentialing”, or characteristics (like length of track record) that look good but aren’t necessarily associated with future performance, similar to unnecessary college degree requirements that keep strong candidates from jobs.

This process should also feature enhanced assessment of cognitive diversity for all managers.

Well-rated strategies are expected to produce outperformance, and emerging (smaller/newer) strategies may have an advantage due to being more nimble and motivated, and diverse and non-diverse strategies (after controlling for size/newness) may be expected to perform similarly.

Therefore, the overall portfolio can be expected to outperform, and there is no expected performance cost to increasing diversity and achieving impact.

In some cases, for purpose of definition of emerging products, the size of the cohort of strategies pursuing the same sources of alpha in the marketplace may be used, rather than individual product size. This is because, sometimes, the increasing asset level that is relevant for degradation of alpha is that of the cohort of similar strategies, not one single strategy.

Impact: At the same time, there is an adjustable level of active risk, and an adjustable goal of impact without sacrificing performance (though diverse managers will be harder to source given lower representation.)

Some asset owners seek positive impact with their investments; a majority say that diversity is important in manager selection. Direct impact in investing can be challenging, but investing with diverse managers is a clear way to achieve measurable impact, as each dollar of investment increases diverse assets under management and helps develop this market segment.


Risks: Emerging managers may be expected to have higher investment and operational risk, meaning that investors should be willing to accept these higher risks (though active risk is adjustable, from very low to high), a strong operational due diligence process is required, and the active portfolio needs to be adequately and carefully diversified.

Graduation and incubation: A unique consideration of this sort of program is that part of the investment rationale is the newness/small size of the managers; so, unlike a traditional active manager program, there needs to be a mechanism to reconsider allocations to managers as they grow and age. An ideal scenario would be a graduation approach in which successful managers move from this program (which should be integrated into the relevant asset class, such as public equity from the beginning), to the rest of the asset class.

There should also be a component of services to the underlying managers to help them scale, perhaps through a third-party consultant or incubator.

Current environment: Lastly, with current legal challenges, those wanting additional diversity and impact in their investment programs may be looking more closely at their processes. An emerging/diverse manager program as described above can be expected to outperform (based on manager research expectations), without an expected performance effect from increased diversity and impact.

If the impact dial for the program is set at its lowest point, investors can still expect greater-than-industry-average exposure and impact with diverse managers (since diverse managers are a larger percentage of emerging managers than the broad market) without specifically targeting or mandating diversity in their specific manager lineup.

Keywords: investments