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  • Writer's pictureSunil K Pai, CFA

5 Keys to Making Those Active Investment Bets

Quant funds are having a difficult start in 2018 and that's everyone, regardless of size or tenure.

You know its media worthy when you hear names like Renaissance Technologies, 2 Sigma, Systematica (et al) mentioned in one article. These are all top firms, well respected and having a difficult year. Nothing new as every investment strategy has its moment in the sun when it can do no wrong and darker days too.

Which brings us to a common theme, do you try chasing your way to higher long-term performance by buying when a strategy is struggling or jumping to the current higher flyer? It's well known that most in the business performance chase their way to an answer - it's a lot easier than digging into an investment process sufficiently to make a sound decision.

Proper diligence is far more than the brand name, track record, fund size, fund costs, and who the fund admin and auditors are. Look, if any of those gave you the magic answer, then anyone could attain outperformance by doing such "diligence". In fact, the reality is in today's market, such diligence criteria could lead to adverse selection. That's where one biases decisioning to the worst cadre of investment managers - stark solace but this is where the majority of this industry sits. Not surprisingly, it is also why many are going the buy and pray route of passive vs the generally lackluster active management route.

So, try these five criteria and see if you can get closer to the right active investment strategies:

1) Illiquid or liquid investment - how long does it take to get your money out of the fund? Any active investment strategy wherein you can get your money out fast is not likely to outperform.

2) Buy a strategy when its down versus when it is up. NO strategy goes only in one direction. So, if you like it when its up, then buy and love it when it is down, especially if down a lot.

3) Volatility, find it and buy it, learn how to control your emotions when volatility takes you on a drawdown because if you get #5 below right, then you will get that drawup if you stick with the strategy. You won't meet your long term retirement targets without taking on risk and staying strong during the inevitable drawdowns.

4) Look for investment strategies that do something with all that liquidity (assuming you are looking at liquid asset classes); meaning if the strategy buys and holds an investment for 1-3 months or more, the possibility of alpha is slim.

5) Always insist on buying active strategies that ONLY deliver more upside return volatility than downside return volatility over many investment decisions measured on a daily basis.

One caveat, none of the above will help you if you suffer from "short-termism" in your investment decisioning. And, this list is not all inclusive--you might be amazed at what prior return distributions can tell you about future fund performance potential.

So, forget about the standard "diligence" -- waste of time and money. Get the five factors above into your diligence toolbox first, then worry about the standardized criteria thereafter. Try to prevent the adverse selection common to most strategy and manager diligence.

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