Liability-Driven Investment

CHAPTER 5Building Investment Portfolios: Part 2: Fund Selection

A tremendous amount of literature exists on fund and manager selection, even though as noted in the prior debate on the merits of passive versus active investment; some investors and academics are sceptical of the value generated by picking an active manager. Many studies have shown that simply passively tracking an index or benchmark will likely lead to similar returns at lower cost and with better liquidity. However, there are a broad array of assets where low-cost trackers do not exist and there exist a great number of specialist managers with track records demonstrating outperformance and managerial skill in differing market conditions.

In a world where many types of investor are unable or unwilling to directly invest in individual securities, fund managers or fund instruments must be selected to create investment portfolios. Funds also have the advantage that they allow investors to diversify portfolios easily and at low cost. A small investor investing directly into multiple stocks would often have to choose between high transaction costs to diversify their portfolio, or overly concentrated positions leading to higher volatility than the expected return can justify. Because of this, the existence of funds is vital in providing low cost diversification to investors large and small. But it can be seen that when an investor decides not to invest directly in securities, they simply replace one decision with another. ...