On 29 September 2009 a sell-out crowd attended the Toronto CFA Society lunch “Evaluating Investment Managers.” Here’s a summary of the panel discussion, which featured:

• Sharon Wilson, CFA, CFP, principal, regional manager research head at Mercer
• Benjamin F. Phillips, partner, director of research, Casey, Quirk & Associates
• Kathleen Wylie, CFA, senior research analyst – Canada, Russell Investments

Top drivers of long-term success

When it comes to assessing investment managers, pension consultants are dedicated to seeking out and recommending those with the highest potential value-add for their Recommended lists. While last year’s market volatility didn’t change the assessment process, it sure highlighted the success or failure of a manager’s practices. So what does it take to get – and stay – on the lucrative Recommended list of a pension consultancy? Pension researchers rate managers based on confidence in the managers’ ability to outperform and help clients select managers that fit their objectives. While there’s no specified checklist of criteria to meet, here are five key factors that pension researchers say they emphasize.

What makes the manager stand out?

Researchers want to meet face to face with the people responsible for making the investment decisions and get an understanding of how they think. Good managers stand out because they have an investment approach that they can repeat over and over. Whether it’s fully qualitative or quantitative or even a combination of both isn’t important; it must be grounded in good investment theory and be a process that managers stick with at all times – even when there’s no bottom to the market in sight. Bad markets can provide a learning opportunity but the actual process shouldn’t’ change. And the approach has to make sense. For example, global equities managers at small Canadian firms have to be able to explain how they conduct global research given their staffing limitations and the immense number of investment opportunities that are available.

As much as the process has to be distinctive, it isn’t enough on its own. Researchers want to see that the manager has an edge on the competition when it comes to idea generation. How do they foster innovative and creative thinking? And how are managers successful at forming unique insights that lead to better proprietary views?

Other questions that will come up may include: how does the portfolio construction process work? What risks are managed and what are some of the hidden risks in the portfolio? How is risk management integrated into the investment philosophy? If the portfolio shows high turnover then what’s the contribution made by the trading team to performance, and how is best execution achieved?

To some extent there can be some understanding built up over years of due diligence, which can make it easier for a researcher to retain confidence in the team, even if the managers are struggling.

How stable is performance?

Managers should be able to show that the performance patterns fit with expectations and are aligned with the investment philosophy and fund objectives. For example, should the manager under or over-perform in down markets, during small cap rallies, etc. Researchers want comfort regarding the stability of the excess return the portfolio team is generating. What performance pattern can be expected – how is it related to the market?

The process may be repeatable but will the team that generated the good performance remain and what’s the likelihood of their success in the future? While many things can trigger a review and possible downgrading of a firm, nothing raises flags more than the departure of a key portfolio manager. So researchers investigate how the investment objectives match up with staffing and compensation structure and career development. What evidence is there of long-term incentives that balance shorter-term incentives and discourage taking undo risk to achieving the investment objectives? Is there a well-managed process for ensuring a team is happy? For compensation practices, there should be a clear articulation of the structure, which should consist of two levels, short-term compensation and deferred. And in addition, for high-turnover portfolios, how are the traders compensated? They should be treated equally to the portfolio managers in terms of compensation and recognition, while staff departures need to be explained – and can be a negative.

Companies need to articulate any changes in these processes – are they taking more time to hire now or have there been any adjustments to the long-term incentive plan?

On the other hand, how are staffing cuts handled and where are they made – on the investment management side or the client services side? At what point are managers let go – the major risk factor when hiring and firing managers is underestimating the transition management for the portfolio – so there must be a process in place for this.

Is the business aligned with beneficiaries?

Researchers want to see that investment professionals also have some ‘skin in the game’, i.e., ownership or investment of their own assets in the funds. Beneficiaries are also more comfortable with a financially strong company, so researchers will evaluate how the company is structured, is it well capitalized? Does it carry a lot of debt? What’s the culture of the firm? How is ownership in the firm distributed to junior people?

In a publicly traded firm, researchers will have concerns that managers may have little say over capacity or have limited autonomy and not want to stay on. Sometimes the senior management of a firm may have a desire to manage and deliver on earnings over the short term in a way that conflicts with building long-term value for investors. Or disclosure around the highest salaries to shareholders may put portfolio managers in an unwanted spotlight – or result in lower compensation for high performers. If a small firm has been purchased by a larger organization, researchers will assess how well the culture is being protected.

On the plus side, well-capitalized firms can afford to beef up their staffing in a downturn, which gives them an advantage as the economy improves. Plus there are benefits to scale – more assets may mean better investment tools. On the other hand, small firms have to consider succession planning challenges which can affect performance.

Researchers are also fielding more requests from retail shops that hope to diversify their revenue source with institutional business. Some may not have invested in institutional-style reporting systems, making assessments more of a challenge. Often their investment philosophy or investment objectives don’t align with the institutional market, i.e. the managers hold large cash balances or may be less pure in terms of the fund objectives; for example, holding foreign securities in a Canadian equity fund.

So what does it take to get – and stay – on the lucrative Recommended list of a pension consultancy?

How is capacity managed?

Researchers want to see that the manager sets reasonable limits and then validates them. Researchers will challenge managers by looking at the holdings but managers could do a better job of showing researchers how they manage this at the security level.

Eventually firms come up against capacity constraints, when size begins to erode the investment opportunity. What consideration goes in to how large a portfolio can become and when it should be closed off to new entrants? Researchers will be looking to see how long it’s taking to get in and out of new positions. In particular, capacity is important for small-cap portfolios as these typically show less liquidity, limiting how nimble the manager can be. Other questions arise if researchers see fractions of full holdings on the books. Why wasn’t a full weighting purchased in the position? Did the market move away before the position was bought? And how frequently does this happen and how concentrated is the portfolio? Finally, a high turnover process requires more liquidity whereas a buy-and-hold strategy can have a higher capacity.

What’s the company culture?

This can vary from questions about how the portfolio managers are consulted, to how much say do they have in capacity and resources, to how the culture works to support managers’ performance. Who decides who is laid off? What commitment is there to ensure that talent is allowed to shine through? Some firms will require the portfolio managers’ role to include time on marketing or even help executing on trades – it’s important to look at how much as generally that’s not favourable.

There will also be interviews with the business leaders and an evaluation of their style and what the firm stands for. How do they maintain the firm’s brand consistency internally? How does the firm foster creativity? Researchers will also want to meet one-on-one with analysts. Are they career analysts or are analysts being promoted to portfolio manager – what’s the analyst turnover? How does the culture ensure investment priorities and the firm’s own internal business practices don’t conflict? Portfolio managers are working for the clients whereas the business managers will be working for the owners. The answers are specific to each firm, and while there’s no right or wrong answer, the process is designed to link back to how the culture may impact the stability of the investment returns.

Ongoing monitoring

If something changes, researchers will investigate and perhaps re-evaluate. For example, if a manager is struggling, is it the environment or is the process broken? If there’s strong long-term performance but signs of struggle over the short term, where’s that coming from? Plus, it’s important to look at what the magnitude of the underperformance is. While all value managers may underperform during certain markets, it’s only the best value managers that will be recommended. It’s just another reason why being able to articulate what drives alpha is so important. Taking a manager off a recommended list is a big step. Consultants don’t want to do this at the wrong time, so are willing to take their time to evaluate such situations.

Summing up

The final question of the session asked the panellists to comment on the one most important thing a manager can do. The answer? Not too surprising – it’s all about how you differentiate yourself against your competitors.