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To find undiscovered investment strategies, financial advisors must perform due diligence that goes beyond track records.
Finding undiscovered investment strategies – whether in a mutual fund, ETF or SMA – before they become widely known for generating alpha is the holy grail for investment advisors. When you succeed, you secure the benefits of a good investment for your client, and you look smart. More importantly, you appear prescient – everybody wins.
There are many elements that go into choosing a best-in-breed asset manager and I will state my bias: Boutique asset managers, by their very nature and structure, can provide a competitive investment edge. Allocating client assets to a boutique manager incurs risk and requires due diligence beyond a review of track records and fees.
The strengths of boutique asset managers begin with their origin story. It usually involves a talented group of investors who grew frustrated by the constraints and competing interests at their former large firms and left to start their own enterprises to gain the freedom and flexibility to invest according to their convictions.
In my experience, managers intrepid enough to set out on their own see investing as a calling, not a job. They love investing almost to the point of obsession and they have a relentless drive to succeed. The structure of such firms often closely aligns the investment team’s interests with the client’s objectives. Boutiques are typically owned by the founders and other key personnel, and they succeed when their clients do.
Further, because boutiques often specialize in a single asset class or strategy, the investment team can stay philosophically aligned around a single process. The business is focused solely on investing with a strategy lineup that capitalizes on the team’s core competency. Boutiques avoid the distractions that often come with multi-million-dollar marketing budgets and layers of management that stand between a firm’s core investment philosophy and the C-suite executives responsible for the strategic direction of a firm.
I have found other strengths common to boutique asset managers. They can pivot. To maintain their investment edge, the best asset managers understand that they must fine tune their investment process as markets, industries and economies evolve.
Boutiques tend to be more entrepreneurial, with ownership stakes shared among a greater percentage of management than at much larger firms. And since the day-to-day business of the firm is typically handled by the same small group of executives making the investment decisions, there is little to no corporate hierarchy necessary to make refinements. Compared to bigger firms, boutiques are free to make necessary changes.
Effective managers also have an acute awareness of their behavioral biases and put processes in place to mitigate the risk of falling prey to them. For instance, to counter the risk of confirmation bias, some firms assign “devil’s advocates” to take the bear case in every investment discussion. Others conduct regular post-mortems to determine if a decision was good, bad or simply lucky or unlucky.
Some form of this process takes place at firms of all sizes, but boutiques take post-mortem sessions to a different level. These lookbacks are often part of their DNA because they won’t allow innate biases to color their judgment. Simply put, their survival depends on getting it right. It helps too, that boutiques tend to be organizations with a lot of open dialogue and discussion that takes place informally in addition to regular meetings.
Choosing the right firm
Boutique investment managers are typically original thinkers who are willing to diverge from consensus. This results in distinctive portfolios that differ from the broad market and peers. Partnering with these high-conviction managers requires a long-term view and adherence to appropriate performance expectations.
Identifying a boutique asset manager at the start of its growth trajectory can be exciting. But it comes with analytical challenges as there may not be a history of performance and portfolios to evaluate. In such cases, instead of track records, investigate the qualitative aspects of the investment process. This is an effective method because past performance isn’t particularly helpful in identifying future outperformers.
That said, even new firms provide avenues for quantitative analysis. For example, boutique founders typically have honed their skills on strategies at other firms, providing an input into the research. Quantitative analysis is less about raw performance and more about understanding the sources of risk and returns. The aim is to identify managers who generate outperformance that is driven more by idiosyncratic decisions than factor or style exposures. Quantitative boutiques can run back tests, which also serve as a data source to test an investment assessment. There are drawbacks and limitations of back tests, but they can clarify a strategy’s risk profile and portfolio biases.
Establish appropriate expectations through the initial investment due diligence. At the outset of a partnership, document a clear and explicit set of expectations for portfolio characteristics and performance. This serves as a touchstone to monitor investment partners. It helps to remain invested when a strategy inevitably hits a rough patch, provided the underperformance is consistent with the strategy’s biases and style. It also prompts further analysis when performance and portfolios run counter to expectations.
Kristof Gleich is the president and CIO of Harbor Capital Advisors. He oversees all investment, distribution, marketing and executive office functions at Harbor. He provides insight while helping lead Harbor’s strategic growth plan.
Originally published on Advisor Perspectives on July 17, 2023.
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