Finding Fortune: How Do Institutional Investors Pick Asset Managers?

The article focuses on a theoretical and empirical analysis of private information acquisition and decision timing by institutional asset allocators when selecting outside hedge fund managers. Using unique data from an institutional allocator's due diligence interactions with 860 long-short equity hedge funds, the study finds that private information complements public signals, enabling the allocator to reduce due diligence time by an average of 18 months and select managers who outperform peers by approximately 9% over 20 months. The authors develop an informed Berk and Green (i-BG) model in which the allocator strategically invests effort to refine signals about manager skill before the broader market, balancing the costs of due diligence against the benefits of early investment ahead of decreasing returns to scale (DRS). Empirical proxies for information collection intensity, derived from meeting frequency and natural language processing of meeting notes, strongly predict both manager selection and subsequent excess returns, supporting the model's predictions and highlighting the role of in-house research in improving allocation efficiency. The study also documents a bimodal distribution of due diligence durations corresponding to "young" and "established" managers and shows that excess returns decay over time as market assessments converge, consistent with capacity constraints and DRS effects.