Investment manager selection: a case study
We have written extensively about investment manager selection at Westminster Consulting. However, we have discussed this only in a general way, describing the process in broad strokes but lacking specificity. Today, we are trying something different: we will present a hypothetical investment manager selection as a case study. After reading this short case study, we hope you will agree this process is as much an art as it is a science.
Our fictional client - Acme Accountancy
Let’s consider a new client - the Acme Accountancy 401(k) retirement plan. Acme Accountancy changed their recordkeeper to Phoenix Investment Bank in 2017. In 2018, Acme hired Westminster Consulting to provide ongoing fiduciary oversight. As part of their migration to Phoenix, they received competitive pricing for using Phoenix’s passive index target date series. Since Acme recently made large changes to their retirement plan, their investment committee won’t allow changes to the plan structure, stable value fund, or target date series, for a year at least. They will, however, replace individual managers in their investment lineup.
As Westminster Consulting prepared its first quarterly review of Acme’s investments, we discovered their large cap growth fund was failing to meet several important criteria documented in the investment policy statement. Westminster conducted a search for a replacement large growth manager. Acme was engaged in the replacement process; they made it clear that they did not simply want a single replacement candidate presented to them, but they wanted to understand the process and steer the results based on their preferences.
Reduce potential candidates using quantitative metrics
For simplicity, Acme only wanted to consider mutual funds, although there are more separately managed accounts, CITs, and so on. Still, when referencing the Morningstar database, there were 1493 investment managers in the US Large Growth category. That was too many replacement candidates to fairly evaluate, so we limited this list using appropriate screens. We began winnowing this down using quantitative criteria – those measurable in an absolute, numeric, or objective way. First, we applied a comprehensive proprietary scoring screen which includes track record, asset minimums, raw performance, style consistency, and asset type. After adjusting this proprietary screen on 1-year, 3-year and 5-year scores, we were left with 168 potential candidates.
From this point, we tightened up key risk-adjusted return metrics (Sharpe Ratio & Alpha, specifically) to the top 20% of performers. We also selected the least expensive 40% candidates; we did not want to be too aggressive with fees because only passive, index-based candidates would advance when costs are emphasized over all other criteria. Applying these screens culled our list down to 27 potential candidates.
Next, we included candidates with at least five-year investment manager tenure. Manager tenure is important because it implies organizational stability and because we want the fund’s current decision makers reflected by recent performance history. We further refined the screen to only include funds which were open to new investment. Finally, it is quite common for multiple share classes of the same fund to get through the screen, so we selected the least expensive share class available. After all sorting, we were left with a very manageable list of six potential candidates.
The six candidates are:
- New York Large Growth I
- Los Angeles Large Growth R6
- Chicago Large Growth Contrafund
- Houston Large Growth R6
- Philadelphia Large Growth
- Phoenix Russell 1000 Growth Index
Evaluate candidates with qualitative metrics
Our selection process thus far had been based on quantifiable metrics, but the art of investment manager selection took the fore as we considered qualitative due diligence criteria, often referred to as the “4 Ps”: philosophy, process, people, and parent.
Philosophy – this represents the investment manager’s core investment thesis, their goals, and how these beliefs are represented in the fund. A fund with an overarching belief in the efficiency of capital markets might take a passive index-based or rules-based approach. In contrast, a fundamentally driven fund might believe superior research or industry contacts might identify superior investment options. If you’d like to know more, search Westminster Consulting’s website for articles on competing philosophies including socially responsible investing, quantitative investing, or technical investing.
Process – this represents how security selections actually happen. For instance, a large cap growth manager might select their ideal choices and, if those selections happen to be concentrated in one sector, so be it. Competing growth managers might purposefully target their best picks in each sector in order to diversify away sector concentration risk. Another example: one fundamental growth manager may target companies with the highest growth rates, no matter how expensive, while a competing large cap growth manager exclude the highest growers if valuations are above a threshold. Investment styles (e.g. momentum growth vs. G.A.R.P. growth) are often manifested through these procedures investment managers use to create their stock portfolios.
People – this represents the actual decision makers behind the investment product. Are the actual buys-and-sells determined by powerful individuals at the top of the pyramid, like Warren Buffet? Alternatively, are decisions meted out between many portfolio managers and vetted against teams of analysts and sector specialists? How is succession managed? Do the decision makers personally invest their own money into the fund and how much?
Parent – this represents who owns the product. Does a large public company – like a bank or mutual fund company - operate this fund or is this a privately-owned, independent boutique with limited clientele and focus. Does the parent allocate sufficient resources to the team to generate value for investors? Is the parent compensating the personnel enough to minimize key staff turnover?
The deciding factor: tailoring your results to the client
Now that we have some background on the qualitative criteria, we can apply them to further refine our candidate list. As a reminder, we arrived at six potential candidates after our quantitative screens. These investment manager searches do not take place in a vacuum – they are for the benefit of our clients. The six candidates have already passed several fiduciary hurdles and the reality is several of these candidates might be equally prudent large cap growth options for multiple clients. Furthermore, one investment manager may be best suited to Acme Accountancy while another investment manager from the list may be better suited to a different client based their unique situation. In other words, determining the ideal candidate depends on their distinctive needs. Evaluating the qualitative criteria and unique circumstances of the client will focus the ultimate recommendation.
Starting with six candidates
In our example, Acme Accountancy 401(k) is currently being held at Phoenix. Phoenix has an “open” architecture; they allow competing investment managers on their platform to serve their clients. However, sometimes the investment managers themselves limit their products to their own platform. Specifically, Chicago Large Growth Fund is one of the six candidates, but it is only available on Chicago Bank’s recordkeeping platform. Clients who are deeply interested in Chicago Large Growth but using a Phoenix as their recordkeeper could consider their sibling, hybrid fund – the Joliet Large Growth fund - as an imperfect, but available, replacement. Acme has no great compulsion to use neither Chicago fund nor its sibling. Now, the list is five candidates.
Acme Accountancy, as we pointed out, is already using Phoenix’s passive, index-based target date retirement fund series. Because the passive target date funds represent a large proportion of the total plan assets, their investment committee would prefer a complimenting, actively managed large cap growth fund in their lineup. Therefore, we can drop the Phoenix Russell-1000 Growth index. Now, the list is four candidates.
When explaining the reasoning for omitting the Phoenix index from the candidate list, Acme came to a realization that a high active share, which should complement the existing, target-date series, might become a favored attribute. Thus, Westminster began the process of sorting the remaining candidates by active-share (i.e. how different the individual funds look from the index) and presented their results to Acme. Upon deeper review, Acme realized that the concentrated Philadelphia fund – with only 30 stocks in the fund – was perhaps too idiosyncratic for inclusion in a 401(k) plan. Ironically, while searching for a potentially positive attribute (high active share), Acme determined they had reached a comfort limit with a fund too distinctive for placement on a 401(k) plan which must cater to many investors. Now, the list is three candidates.
As part of its research, Westminster Consulting learned about recent manager changes in the New York Large Growth team in 2018. While the fund, historically, still has exceptional results, the apparent succession planning (including unanticipated advancement of a co-PM in April 2018) spurred the team to pass on it. Now, the list is two candidates.
The final two
Ongoing discussions with the investment committee helped them to verbalize their desires for the large cap growth replacement. Yes, they wanted a fund which meets the fiduciary standard, and yes, they wanted a fund to provide stylistic diversity given the existing investment options in the lineup. They also wanted a fund with the potential to distinguish itself positively from peers in a consistent way. They weren’t counting on blow-out years, but instead preferred continually good chances for beating the index or peers. In a search for consistent outperformance, Westminster determined the “batting average” of each candidate – their historical record beating the index in any given year.
For the final meeting, Westminster Consulting presented information about each of the final candidates, their process for selecting stocks, and how they distinguished themselves their peers. So, what does Acme pick? They liked the patient, sector-neutral, and socially-responsible investment tilt from the Los Angeles Large Growth fund. However, they ultimately picked the more-active, higher-quality, sector-bettor Houston Large Growth fund.
In summary, the process of selecting an investment manager for a plan is driven by the client’s unique circumstances, legal precedent, objective quantitative criteria, subjective client preferences, indefinite qualitative factors, and common sense. There is as much art to this process as there is science.
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