Manager Selection - The Single Most Important Skill in Alternatives
By EC Assets Research Team, Manager Research · Published · Updated
Manager Selection — Manager selection is the institutional discipline of identifying, evaluating, and allocating to investment managers. For alternative investments where manager dispersion exceeds asset-class dispersion, manager selection is the dominant determinant of investor outcomes.
Definition
Manager selection is the institutional discipline of identifying, evaluating, and allocating to investment managers. It encompasses sourcing potential managers, conducting investment and operational due diligence, negotiating terms, monitoring ongoing performance, and making redemption or re-up decisions. For institutional investors with allocations to active or alternative strategies, manager selection is one of the few decisions over which they have direct control, and is the dominant determinant of investor outcomes within those allocations.
The discipline gained recognition through the academic and practitioner work documenting manager-return dispersion. The seminal demonstration was Yale's endowment under David Swensen, which achieved sustained top-decile performance through aggressive manager selection in alternative asset classes. Subsequent academic work confirmed that manager selection (rather than asset allocation timing or factor exposure) explained the majority of variation in institutional returns within alternatives.
What makes manager selection difficult is that it requires distinguishing genuine investment edge from marketing presentation, evaluating qualitative factors that databases don't capture, accessing managers who restrict allocator entry, and maintaining the discipline to hold through long underperformance windows.
Why Manager Dispersion is So Wide in Alternatives
Manager dispersion in alternative investments exceeds dispersion in traditional asset classes:
| Asset class | Top-quartile annual net return | Bottom-quartile annual net return | Spread |
|---|---|---|---|
| US large-cap equity (active) | 12-14% | 8-10% | 4 pp |
| US fixed income (active) | 6-8% | 4-6% | 2 pp |
| Hedge funds (diversified) | 12-18% | 0-4% | 14 pp |
| Private equity (buyout) | 18-25% | 5-10% | 15 pp |
| Venture capital | 25-40% | 0-5% | 30 pp |
| Real estate (value-add) | 13-17% | 5-8% | 8 pp |
The wider dispersion reflects three structural features of alternatives:
Information asymmetry. Public markets are highly transparent; alternative managers can have meaningful information advantages.
Capacity constraints. Many alternative strategies have limited capacity for capital. The best managers don't accept all available capital; access matters.
Operational complexity. Alternative strategies require more operational infrastructure. The gap between well-built and poorly-built firms shows up in performance.
[!key] Within venture capital specifically, the difference between top-decile and median fund returns has averaged over 15 percentage points annually across multi-decade studies. This is larger than the difference between equity and bond returns. The category exists as an asset class primarily because the top managers' performance justifies the operational complexity; allocating to median venture is allocating to a difficult, illiquid asset class with little expected premium.
The Skills That Define Great Selectors
Multiple academic studies and industry practitioners point to a consistent set of skills that differentiate top allocators:
Pattern recognition. The ability to distinguish genuine investment edge from compelling but ultimately empty marketing presentations. This skill is built through extensive exposure to many manager pitches, structured comparison of which ones succeeded and failed, and explicit reasoning about what drives outcomes.
Institutional access. The best managers don't accept all comers. Top venture funds, sought-after hedge funds, and oversubscribed private equity funds restrict entry to investors they've worked with previously or who can demonstrate strategic value. Access is built over years through relationships, reputation, and ability to commit meaningful capital.
Patience and discipline. Top managers go through multi-year periods of underperformance. The value factor underperformed for over a decade through 2020. Some of the best long-term venture funds had specific vintage years that underperformed. Maintaining commitment through these windows separates good selectors from those who chase recent winners.
Cognitive bias awareness. Manager selection is subject to multiple cognitive biases (recency, narrative, anchoring, availability). Sophisticated selectors maintain explicit processes to counteract these biases, including documented decision rationales, post-decision reviews, and dissenting-view requirements.
The Common Errors
The most frequent manager-selection mistakes follow predictable patterns:
Persistence bias. Allocating to recent winners under the assumption that performance will continue. Empirically weak as a strategy for hedge funds; somewhat better for private equity and venture but still imperfect.
Narrative bias. Preferring managers with compelling stories ("we trade what others cannot see", "we have a proprietary edge", "we are positioned for the next regime") over managers with verified, replicable processes. Stories are easier to sell than systems but harder to evaluate.
Access bias. Allocating to whichever good manager is currently accessible rather than building toward the best managers over time. This often means allocating to second-tier managers in current vintages rather than waiting for entry to top managers in later vintages.
Concentration bias. Allocating heavily to a single great manager when diversification would reduce risk. Even great managers experience drawdowns; concentration amplifies the impact of any one decision being wrong.
Implementation: How Institutions Actually Do It
The operational practice of manager selection varies by institutional sophistication:
Large institutions with dedicated teams (pension funds with 10+ alternatives staff, large endowments, sovereign wealth funds) typically conduct direct manager selection in-house. They maintain ongoing relationships with hundreds of managers, conduct first-hand due diligence, and have multi-decade institutional knowledge of which managers have succeeded and failed.
Mid-size institutions typically use a hybrid model: in-house team supplemented by external consultants. The consultants provide broader market coverage and operational due diligence; the in-house team makes ultimate allocation decisions.
Smaller institutions typically use consultant-led mandates, where the consultant selects managers on the institution's behalf. Common consulting firms: Cambridge Associates, Mercer, Aksia, Albourne, Verus, Willis Towers Watson. Each has specific areas of strength and weakness.
Fund of funds is a fourth approach: outsourcing manager selection entirely to a specialised fund of funds. Adds a fee layer (typically 50-100 bps additional management plus 5-10% additional carry) but provides diversified access to multiple managers. Most institutional fund-of-funds usage has declined as direct selection capabilities have grown.
Common Misconceptions
"Past performance predicts future performance." Weak relationship for most active manager categories. Persistence is real but smaller than intuition suggests, and most allocators systematically over-weight recent results.
"All consultants have similar access." False. Top-tier consultants have meaningfully better access to top-tier managers than less established firms. This is one of the structural reasons consultant selection itself matters substantially.
"Manager selection is unpredictable." Specific manager outcomes are unpredictable; aggregate skill is real. Top-tier allocators outperform median allocators consistently across multi-year periods, suggesting genuine skill exists. The question for smaller institutions is whether they can develop or access that skill.
References
- Grinold, R. C., & Kahn, R. N. (1999). Active Portfolio Management (2nd ed.). McGraw-Hill.
- CFA Institute. Manager Selection. CFA Program Curriculum.
Frequently asked questions
How important is manager selection vs asset allocation?
For traditional portfolios (60/40 equity-bond), asset allocation explains 80-90% of return variance and manager selection explains 10-20%. For alternative-heavy portfolios (50%+ in hedge funds, private equity, venture), manager selection can explain 50%+ of returns because manager dispersion within these categories is enormous. Yale's success was attributed primarily to alternatives access and manager selection, not asset allocation.
Why don't most institutions just use top-tier consultants?
Three reasons. First, capacity constraints — top consulting firms have limited capacity for new institutional clients. Second, alignment — consultants serve many clients with similar mandates, creating crowding into the same managers. Third, scale issues — small institutions may not be able to access the same managers that consulting firms can offer larger clients.
What is persistence bias in manager selection?
The tendency to allocate to managers whose recent performance has been strong, assuming the performance will continue. Empirical evidence shows that hedge fund performance does not persist strongly year-to-year; venture capital shows more persistence but mostly through manager-quality differences rather than year-to-year continuity. Mechanical allocation to recent winners systematically underperforms thoughtful manager selection.
How do you find good managers without existing access?
Slow build. Multi-year process of building relationships, attending industry events, working through capital introduction platforms, hiring experienced personnel who bring relationships, and accepting that the first allocations may be to second-tier managers while building visibility. New allocators often start with consultant-managed mandates to build relationships before doing direct manager selection.
Are manager databases (Preqin, eVestment) useful?
Limited utility for top-quartile manager identification. Databases provide quantitative comparisons but miss the qualitative dimensions that distinguish top managers. They are useful for monitoring known managers and screening potential candidates, but selection decisions require direct due diligence beyond database analysis.
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