Is there too much emphasis on past performance for asset manager selection and retention? What other factors should a financial advisor focus on? A recent book, “The Trust Mandate,” takes a deep dive into how institutions select investment managers and provides valuable insights for advisors. “Soft” factors may play a bigger role than previously thought.

Attorneys will often go to great lengths to shield a client’s past from a jury who will decide their guilt or innocence. They do this, of course, because they are acutely aware of how prejudicial history can be to the way a jury perceives a defendant.

The same bias for history is present in the investment world.

But in stark contrast to courtrooms, the prejudice created by past investment performance is openly accepted as an integral part of financial due diligence. Among institutional investors, the emphasis on past performance is so strong that many are prohibited from even considering a fund or a manager with less than a three-year track record—because there would be insufficient past performance data on which to evaluate them. While institutions and independent advisors have different behavioral constraints, none are immune to basic human biases.

Such biases and prejudices have long been known to us, and they are either avoided (as in the legal defense process) or welcomed (as in investment manager evaluation), depending on whether interested parties view them as being detrimental or useful. Behavioral science has provided us with a deeper understanding of these biases, but it also tells us how difficult it is to eliminate them.

So, despite the fact that future performance is not well-predicted by past performance, it still tends to be the most highly correlated factor with institutional money flows both to and from investment managers. The reasons for this are that the biases are powerful, the data is readily available, and the alternatives are deemed to be either less effective or immensely more difficult to ascertain.

The bias toward using past performance can be attributed to several known decision heuristics (prewired shortcuts our brain uses to process information and make decisions). First, we are highly prone to favor the most available information. Second, when faced with uncertainty, we look for what we perceive as a reasonable proxy. Third, when trying to estimate something uncertain, we latch on to a reference point, anchor ourselves to that, and then make adjustments as necessary. Past performance data fulfills all of these objectives quite handily.

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If we had the resources, we could theoretically approach investment manager selection the way meteorologists approach the weather—construct a complex model that simulates the conditions around the globe that cause weather and use that to draw conclusions about local areas. Indeed, some institutions or hedge funds may perform a similar task when modeling global markets and then drawing conclusions on which managers will perform best in that environment. But aside from the impracticalities, we don’t really know whether such a process would improve selection accuracy enough to justify the effort.

In short, past performance is the most obvious first step in evaluating the future, and we are all predisposed to take it. But since it is not a terribly good predictor of future performance, are advisors making bad decisions as a consequence?

A recent book titled “The Trust Mandate” by Herman Brodie and Klaus Harnack sheds light on this question through an in-depth analysis of investment manager selection by institutions and pension plan sponsors.

Citing comprehensive studies, surveys, and data from both U.K. and U.S. plan sponsors, Brodie and Harnack point out that while past performance is only modestly correlated with future performance, it is highly correlated with money flows to investment managers.

On the surface, that supports the notion that performance chasing is alive and well. However, asset flows do not all pile into the highest-performing fund or manager of the previous time period, and assets flow into many managers who actually had subpar prior performance. Therefore, other factors are definitely entering into the decision.

Brodie and Harnack see the selection process starting with past performance, but not ending there. Interviews with plan sponsors reveal that past performance is used more as a screening mechanism to develop a short list to which more subjective criteria are subsequently applied. That would explain the high correlation with asset flows, while also confirming that other factors often determine the final selection. The logic of screening by past performance is intuitive. It is clearly one of the easiest criteria to screen for, along with investment strategy and objectives, and at least ensures that the manager is being selected from among the highest performers.

Interviews reveal another reason why past performance is so widely used as a screening criterion among institutions. A common feeling among those responsible for selecting investment managers is that using past performance lowers career risk. For those who may be required to defend their selections ex-post (say, to clients or to an investment committee), should a manager not perform up to expectations, the existence of a healthy track record in the past helps convince the investment “jury” that negative performance was more the fault of the manager than of the selector.

Brodie and Harnack note other interesting insights about the manager selection process. The data shows, for example, that money moving to managers correlates most highly with three-year past performance while money flowing out correlates best with 12-month performance. This reveals that institutions like to go with longer track records of success to initiate a new relationship but are quicker to pull the plug when actual performance disappoints.

Once a short list of high performers is identified, Brodie and Harnack say that’s where the “soft factors” come in. The soft factors are those not represented by the numbers or hard measurements. They are the qualitative or subjective factors, also referred to as the “warm and fuzzy” factors. They would also qualify as behavioral factors.

Final manager selection may well rest on these factors, even though you can’t easily look them up or pull up a chart on them. You won’t find a service that rates managers by these factors, and if you are intent on using them, you will most likely have to do that work yourself. That can be a challenge for practical reasons alone; and if you don’t know what questions to ask to determine how managers measure up on such factors, the task becomes even tougher. Even if you do know what to ask, you aren’t guaranteed to get an accurate assessment, since many of these factors are not easily articulated by the very people you are trying to assess.

According to Brodie and Harnack, the following are the three most prominent soft factors:

• Consistent investment philosophy.
• Clear decision-making.
• Capable investment professionals.

As to consistent investment philosophy, this factor is receiving growing attention. At least one software company, Essentia Analytics, is developing tracking tools that can provide insights on this factor. For now, such insights are being sought by the managers themselves to assist in their self-audit process. For those who use the software, they may now have something they can deliver to financial advisors or plan sponsors who might be considering them. It is clear that investment managers, with or without software to assist them, need to be able to articulate a thoughtful and consistent investment philosophy to potential clients.

As to clear decision-making, a financial advisor, plan sponsor, or consultant should rigorously question the manager about their decision process, who participates in it, and how decisions have been made in past situations. This should naturally lead to discussion of the factors weighing on manager discretion, the degree of manager discretion, and whether strategies are chiefly “mechanical” and rules-based or not.

As to capability as an investment professional, there are degrees and credentials that can speak to that as well (though studies apparently debunk the notion that credentials lead to better performance). The decision-maker (or consultant) must develop their own due-diligence process to determine if the manager has the experience, talent, bench strength, research capabilities, technology, and process to consistently and effectively manage their specific strategies or funds.

In their exploration of the soft factors in manager selection, Brodie and Harnack describe a process that takes place in two dimensions—sizing up the manager’s ability and evaluating their future intentions. They claim that one “cannot evaluate a person’s skill in isolation from their intent. … So, although the two judgments are made independently, relying on a completely different set of signals, they combine to form a unified impression.”

Thus, while a manager’s ability can be assessed with hard factors such as past performance, credentials, and written statements regarding investment philosophy and strategy, the assessment of a manager’s future intentions can be effectively summarized in a single word: trust. If there were no risk, trust would be far less important, but because there is risk inherent to almost all of a manager’s decisions and actions, trust becomes a prime factor in the final decision. In fact, there is plenty of anecdotal evidence to suggest that trust may even override past performance as the deciding factor in manager selection and may figure prominently in decisions to go with managers that exhibit less-than-stellar past performance.

The abstract of the book puts it this way:

It reminds me of advice that my father gave me, as many other fathers probably have over the years: “Choose your friends and your business associates wisely.”

While we cannot help but be influenced in that choice by factors such as education, status, wealth, and careers, in the end, the factors that really tip the scale in building a meaningful long-term relationship are character—and trustworthiness.