Selecting an investment manager
Like other consulting firms, Westminster Consulting selects the investment managers to conduct the day-to-day business of buying and selling securities for clients. A large part of our job is to prudently select, monitor, and (if necessary) replace the investment managers our clients use. This raises the obvious question: how do you select an investment manager?
There are tens of thousands of investment managers, with an overwhelming variety of strategies and investment vehicles to choose from. For instance, if we needed a US Large Cap Blend manager for a 401(k) plan, there are about 1500 mutual funds and ETFs available. Other types of clients – say, an endowment – might opt for a more expansive search, including separately managed accounts, limited partnerships, and alternative investment vehicles. How can anyone sort through them all?
The reality is that no firm goes through every investment option. Some way or another, the thousands of options get whittled down to a more manageable list of candidates. There are a variety of ways to narrow this list. Less scrupulous investment consultants could ignore a prudent process altogether and choose investment managers from a short-list of friendly industry contacts or they could select investments based on which products kick-back the most money to the consultant. (Depending on the relationship with the client, this activity may or may not be legal, but it happens.)
Professional fiduciary consultants use a process to narrow down their investment manager options. For instance, Westminster Consulting uses various quantitative or fiduciary screens on several databases of investment managers to narrow a search down to a manageable list of candidates. Once we have a short list of vetted candidates, what’s the next step?
Westminster Consulting’s due diligence reports
The screens we have used to create a short list of investment manager candidates are based on quantitative criteria: factors which can be converted to a number. These factors include risk- adjusted return, manager tenure (in years), performance, peer group percentile, and so on. Quantitative factors are often the best way to measure the results of an investment manager, but they don’t tell you much about what the manager is trying to do. Is there an underlying philosophy for the product? What is the process for selecting stocks? Who are the people actually making the decisions? Understanding the qualitative factors – the people, process and philosophy - is the next step to investment manager due diligence.
Westminster Consulting creates due diligence reports on investment manager candidates and every active fund used by our clients. These reports are usually 3 or 4 pages long and they highlight key factors – performance, philosophy, process, and people – about a manager so consultants and clients can get a better understanding about the available investment options.
Adding grades to our due diligence reports
We have followed this process for several years, but some of our clients have come to us with a request. Clients would often read the due diligence report and come away with a lot of up-to-date information about an investment manager, but what they really wanted was guidance. What was our assessment? What did we think? Is this a good manager? With this request in mind, we have slightly altered the format of our due diligence reports. The first line - in bold – should now contain a “Westminster Consulting research grade”. There are 5 grades you will see in our due diligence reports: A, B, C, F, or Unrated.
These are the managers in which we have the highest positive conviction. To get an A grade, a manager should have a consistent history of superior risk-adjusted performance and an investment process which gives us greatest confidence in their future potential.
These are the managers in which we have high positive conviction. To get a B grade, a manager should have a good history of attractive risk-adjusted performance and an investment process which gives us confidence in their future potential. Our most common grade is B; it usually reflects a solid manager with one or two factors which prevent an A grade. These factors usually include: a spotty history of excess returns, issues with the parent company, an unanticipated manager replacement, a change of the investment mandate, capacity issues, or a lack of transparency in attribution.
These are the managers in which we have a good positive conviction. To get a C grade, a manager should have a reasonable history of solid risk-adjusted performance and an investment process which gives us confidence in their future potential. Like the B grade, there are usually a few potential deficiencies – quantitative or qualitative – which prevent this manager from scoring higher, but generally Westminster Consulting still has confidence in the product’s advantages.
These are the managers in which we have lost positive conviction. This is our rarest grade since the managers we initially screen tend not to end up here. However, some of our clients have selected managers prior to a relationship with Westminster Consulting. For various reasons, political or logistical, the client chooses not to replace these managers. As part of our process, we will continue to perform due diligence on those managers, even when we’d rather not include them in the lineup.
An unrated score does not mean a lack of confidence in the product. It simply means unrated. Managers can be unrated for a variety of reasons. Most unrated funds are index funds. An index fund often does not require the level of due diligence given to a traditional active manager. If an index fund performs in line with its benchmark, with minimal tracking error, fees, or other operational discrepancies, we are generally comfortable with the product.
Grading on a curve
There is one final thought to leave you with: we are, by necessity, grading on a curve. What do we mean by this?
Our investment process can start with a thousand potential investment managers before our quantitative screens reduce the list to five or six potential candidates. Given this process, you could make a fair argument for each of the five or six remaining candidates receiving an A+ rating. Furthermore, most clients exclusively use investment managers which are a product of this screening process, so you might expect to see only A grades and only the occasional B in the entirety of our clients’ portfolios. We have chosen, instead, to be hypercritical and compare the managers which have made it through our screens. There are about 200 distinct managers and products our clients use and our grading scale sorts the candidates from this vetted list against each other.
So yes, we grade on very steep curve. In practical terms, if you have a C manager in your investment lineup, that is not a reason to seek a replacement. More often than not, a C manager gets the job done very well. A C manager may not have our highest conviction for excess alpha, but there are often excellent reasons to keep them in your lineup.
We hope that the addition of grades in our due diligence reports will give you a better understanding of the managers in your lineup or replacement candidates. Thus far, we have assigned grades to about half of investment managers our clients use. We will be including these grades to our due diligence reports, as they get updated.