The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
Due diligence and investment manager review are critical to hiring an investment manager. Much has been written about the important aspects of finding the best investment manager for the needs of the portfolio. The same filters may be used to terminate an existing relationship.
In addition to passing the criteria necessary to be engaged, it is assumed that investment managers must maintain many, if not all, of those attributes that resulted in engagement. This is not always the case, however. Ironically, the rules seem to change once an active investment manager is hired, even with the existence of a formal probationary period, sometimes called "watch" status, extended to investment managers whose performance has been sub-par.
As fiduciaries, it is important to develop a formal, well-documented and well-understood process for identifying qualified investment managers. Part of the process normally includes the involvement of a professional consultant. Involving a consultant to hire an investment manager, however, does not absolve the fiduciary of his or her duties. The duties are ongoing and the review should remain as long as the investment manager is engaged.
The filters are then incorporated into a robust request for proposal. Fiduciaries must weigh the importance of each of these filters and narrow the field to a small group of finalists who will provide a personal presentation.
Normally, the finalists consist of highly regarded and similarly qualified professionals. At this point in the search process, the presenter's style and a personal connection with their audience may drive the final hiring decision. This may be analogous to the decision to marry after just one date.
Let's look at the difference between qualitative and quantitative analysis from Harvard University's website:
"Qualitative research, in contrast to quantitative research, generally does not translate aspects of the world into numbers to be analyzed mathematically. Instead, it analyzes the world through the lenses the researcher brings to bear on the data."
The above definition of qualitative research introduces an ironic juxtaposition of the interpretation of qualitative and quantitative analysis post engagement. Most often the qualitative filters used “through the lenses the researcher brings to bear on the data” tend to be somewhat fluid in their creation but strictly applied after the investment manager is hired. For example, the consultant may suggest limiting the universe of investment managers to independent investment management firms that only focus on the specific asset class in question, such as domestic equity managers. In the initial search, this filter would disqualify other investment management firms that may manage domestic fixed income in addition to domestic equity portfolios.
Success by the equity-only investment manager (a desired result) may lead to possible suitors and end with the firm being sold to a larger organization. Assuming that the portfolio management team all stayed with the acquiring entity, the investment management strategy remains intact. But if the consultant introduced a filter of a single asset-class focus as having value, thereby increasing the probability of relative outperformance, there is a burden to maintain the filter even after the decision to hire the investment manager. This may result in the termination of the equity-only investment manager because of a violation of the focus filter.
The quantitative filters, on the other hand, are much simpler to grasp, especially for board members who may not have an investments background. Indeed, while the qualitative filters tend to be advocated by consultants as a way to increase the probability of relative outperformance, it is tangible performance that generally leads to the decision to hire. It is also a common cause of the decision to fire.
Although, the consultant may view the qualitative filters as a way to increase the probability of relative outperformance, they will rarely recommend the hiring of an investment manager whose performance has been less than the applicable benchmark over selected time periods. Top performing investment managers are those that populate the universe of "qualified" candidates, further filtered by some risk measures and the consultant's qualitative attributes. The client should not expect, then, to hear that a finalist "has underperformed the S&P 500 Index by more than 2 percent per year over the past six years, but we still recommend them." Rather, the most easily understood and broadly applied search filter is relative outperformance. The expectation is that such outperformance will continue, which contradicts the oft-repeated disclaimer that "past performance is not a guarantee of future results."
A single quarter of poor performance may be seen as an anomaly. Two consecutive quarters of underperformance may get the attention of the consultant and client, generally resulting in the investment manager landing on the "watch" list. If a formal watch policy exists as part of the investment policy statement, it generally includes a stated period to allow the investment manager to recover from prior underperformance. This period may be two quarters or longer. Continued underperformance for a period of two quarters while on the watch list means that the investment manager has underperformed the benchmark for a year!
This takes us back to the work necessary to hire a new investment manager. It is a commitment of time and resources to identify a new investment manager. The decision to begin a search normally follows a commitment to terminate an investment manager. And unless the existing holdings of the to-be-terminated investment manager can be distributed to existing investment managers or held in a passively managed alternative, the losing strategy will be retained until a new investment manager is identified and hired, which may take another few months. This of course, assumes that the necessary investment committee and board meetings coincide with the decisions and do not inadvertently add more time to the fix.
While most investors are committed to a process of due diligence and research in anticipation of hiring a new investment manager, the process to hire can be less costly than the process to fire. Fiduciaries are encouraged to develop a plan in the event an investment manager must be fired for any reason, including performance. Most importantly, minimizing the time it takes to execute the plan should lead to a more strategic allocation and a better result.
William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.
Due diligence and investment manager review are critical to hiring an investment manager. Much has been written about the important aspects of finding the best investment manager for the needs of the portfolio. The same filters may be used to terminate an existing relationship.
In addition to passing the criteria necessary to be engaged, it is assumed that investment managers must maintain many, if not all, of those attributes that resulted in engagement. This is not always the case, however. Ironically, the rules seem to change once an active investment manager is hired, even with the existence of a formal probationary period, sometimes called "watch" status, extended to investment managers whose performance has been sub-par.
As fiduciaries, it is important to develop a formal, well-documented and well-understood process for identifying qualified investment managers. Part of the process normally includes the involvement of a professional consultant. Involving a consultant to hire an investment manager, however, does not absolve the fiduciary of his or her duties. The duties are ongoing and the review should remain as long as the investment manager is engaged.
Applying filters to the process
Once a need for active management has been established, the investment committee agrees to apply certain filters to select the most qualified investment manager. There are many qualitative filters used to narrow the field of investment managers. They may include the experience of the lead portfolio manager and investment team, the application of a unique research process, focus on a particular segment of the market, and even ownership structure. The quantitative filters include all types of return and risk measures, from absolute and relative performance to risk/volatility statistics over various periods.The filters are then incorporated into a robust request for proposal. Fiduciaries must weigh the importance of each of these filters and narrow the field to a small group of finalists who will provide a personal presentation.
Normally, the finalists consist of highly regarded and similarly qualified professionals. At this point in the search process, the presenter's style and a personal connection with their audience may drive the final hiring decision. This may be analogous to the decision to marry after just one date.
Oversight begins
After the hiring decision has been made and the agreed-upon investment strategy has been implemented, the fiduciary obligation of investment manager oversight begins. This includes periodic review that is commonly a quarterly report principally covering performance. But the overview should also include the qualitative filters that were initially required. A well-written investment policy statement contains language that describes the filters and the contraventions necessary to place an investment manager on probation or watch.Let's look at the difference between qualitative and quantitative analysis from Harvard University's website:
"Qualitative research, in contrast to quantitative research, generally does not translate aspects of the world into numbers to be analyzed mathematically. Instead, it analyzes the world through the lenses the researcher brings to bear on the data."
The above definition of qualitative research introduces an ironic juxtaposition of the interpretation of qualitative and quantitative analysis post engagement. Most often the qualitative filters used “through the lenses the researcher brings to bear on the data” tend to be somewhat fluid in their creation but strictly applied after the investment manager is hired. For example, the consultant may suggest limiting the universe of investment managers to independent investment management firms that only focus on the specific asset class in question, such as domestic equity managers. In the initial search, this filter would disqualify other investment management firms that may manage domestic fixed income in addition to domestic equity portfolios.
Success by the equity-only investment manager (a desired result) may lead to possible suitors and end with the firm being sold to a larger organization. Assuming that the portfolio management team all stayed with the acquiring entity, the investment management strategy remains intact. But if the consultant introduced a filter of a single asset-class focus as having value, thereby increasing the probability of relative outperformance, there is a burden to maintain the filter even after the decision to hire the investment manager. This may result in the termination of the equity-only investment manager because of a violation of the focus filter.
The quantitative filters, on the other hand, are much simpler to grasp, especially for board members who may not have an investments background. Indeed, while the qualitative filters tend to be advocated by consultants as a way to increase the probability of relative outperformance, it is tangible performance that generally leads to the decision to hire. It is also a common cause of the decision to fire.
Although, the consultant may view the qualitative filters as a way to increase the probability of relative outperformance, they will rarely recommend the hiring of an investment manager whose performance has been less than the applicable benchmark over selected time periods. Top performing investment managers are those that populate the universe of "qualified" candidates, further filtered by some risk measures and the consultant's qualitative attributes. The client should not expect, then, to hear that a finalist "has underperformed the S&P 500 Index by more than 2 percent per year over the past six years, but we still recommend them." Rather, the most easily understood and broadly applied search filter is relative outperformance. The expectation is that such outperformance will continue, which contradicts the oft-repeated disclaimer that "past performance is not a guarantee of future results."
Decisions, decisions
While not guaranteed, future outperformance is the overwhelming goal of the consultant and the client. With very few exceptions, active investment managers tend to underperform their respective benchmarks over certain time periods. And while violations of some qualitative filters tend to be more quickly enforced with investment manager termination, underperformance is generally met with a wait-and-see response.A single quarter of poor performance may be seen as an anomaly. Two consecutive quarters of underperformance may get the attention of the consultant and client, generally resulting in the investment manager landing on the "watch" list. If a formal watch policy exists as part of the investment policy statement, it generally includes a stated period to allow the investment manager to recover from prior underperformance. This period may be two quarters or longer. Continued underperformance for a period of two quarters while on the watch list means that the investment manager has underperformed the benchmark for a year!
This takes us back to the work necessary to hire a new investment manager. It is a commitment of time and resources to identify a new investment manager. The decision to begin a search normally follows a commitment to terminate an investment manager. And unless the existing holdings of the to-be-terminated investment manager can be distributed to existing investment managers or held in a passively managed alternative, the losing strategy will be retained until a new investment manager is identified and hired, which may take another few months. This of course, assumes that the necessary investment committee and board meetings coincide with the decisions and do not inadvertently add more time to the fix.
While most investors are committed to a process of due diligence and research in anticipation of hiring a new investment manager, the process to hire can be less costly than the process to fire. Fiduciaries are encouraged to develop a plan in the event an investment manager must be fired for any reason, including performance. Most importantly, minimizing the time it takes to execute the plan should lead to a more strategic allocation and a better result.
William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.