TYPICALLY, IN NORTH AMERICA, PLAN SPONSORS GO TO market annually to select hedge fund investment managers for about 150 North American mandates ranging in size from US$5 million to well over US$500 million. This is a globally competitive industry representing approximately US$360 billion in global institutional investor capital today and is expected to climb to more than US$1 trillion by 2010. In today’s highly competitive landscape, for example, it is common for a European manager to actively compete for a C$30 million mandate.

After plan sponsors narrow things down using the four “Ps”(philosophy, people, process and performance), there are many great investment management firms to choose from.

Rarely does a sponsor’s selection process point clearly and distinctly to only one manager hiring decision option. It is often the case that there are usually two to four managers who could execute well on the mandate and work well with the sponsor and/or consultant.

Confounding variables can easily defeat making the “right choice” given that any of the manager subset could do the job. It’s not uncommon to become spellbound by the key personnel, rely heavily on past performance, allocate in a vacuum without consideration of corporate culture or future plans, and use negative selection criteria to eliminate potential winning candidates.

Negative selection criteria can be especially problematic, leading to rejection of the best choice in haste. For example, all managers experience turnover at one time or another. But firms are often evaluated on only a cursory look at turnover numbers, and not the evolution of the organization to better meet client objectives.

But plan sponsors can do a lot more. More than 400 North American plans meet directly with at least 40 hedge fund-of-fund managers each year. There are three key activities that can help shape a plan’s manager selection criteria and lead to better decisions.

First, it’s critical to keep a direct channel open with managers for your own education. Highly constrained benchmark-oriented investment managers will become less relevant. First-hand knowledge is an important asset in working effectively with your consultant. Managers are thrilled to share “real life—in the trenches” stories about successes and failures that will help a plan to assess manager candidates.

Plan sponsors also need to understand that evaluating hedge fund managers is synonymous with evaluating a business. Judicious turnover and succession needs to happen to refresh, refocus and redefine operations to suit the changing marketplace. There is no substitute for seeing written due diligence reports and testing the integrity of a manager’s infrastructure. Think about quarterly meetings with the firm to understand a strategy in more detail to build fluency in strategy dynamics and risk knowledge. Educating committees about hedge funds raises the bar on knowledge of risk and operational issues for any money manager.

Finally, “stardom” is fleeting and managers who are structured to deliver consistently stable riskadjusted returns will win the day. “Headwinds” are driving down returns, and mainstream managers are developing hedge fund-type strategies and structures.

Many plans and consultants wish to avoid contracting with stars because the sponsor’s human resources are limited to follow high volatility and changing risk budgets for relatively smaller pieces of the overall portfolio. Sponsors are wise to assess their internal capabilities, in partnership with their consultants, to understand and monitor their investment with a manager.

Many of the principles described in this quick look at manager selection can be applied in both the alternative and traditional asset management spaces. Combine statistical, analytical and human gut-feeling inputs with first-hand contact. Systematic decisions as an educated sponsor will likely lead to better decisions.

Rupert Allan is president of Tremont Group Holdings, Inc. in Rye, N.Y. rallan@tremont.com

For a PDF version of this article, click here.