Investment-Manager Selection in Focus
In today’s marketplace, institutional asset owners such as pensions, endowments and foundations can select from a broad array of choices when designing and managing portfolios. While many consultants begin the task of manager selection by describing the investment process and skills of the manager, a better framework is top-down and starts with an assessment of the institution’s decision-making process and resource structure. Once the consultant understands those essential characteristics, he or she can better develop a plan that facilitates the needs of the institution.
The core functions of an institution’s decision making require a CIO, portfolio management, research, custody of assets, cash management, fund accounting, trading and performance reporting. While all institutions have a board to oversee the management of the assets, not all have the same levels of internal resources. Larger pension plans or endowments can have a large internal staff providing many key decision-making elements in house. Alternatively, a small plan may have very few internal staff wherein the entire decision-making apparatus is outsourced.
Within the traditional consulting model, the institution relies on the consultant to conduct an asset-allocation study, and research and select managers that best fit the institution’s investment goals and objectives. The finalist managers from that initial vetting process present to the board, which then negotiates fees with prospective managers before final selection. Other core functions are typically administered by the institution, including selection of a custodian, cash management, and fund accounting; the consultant generally provides performance reporting. This model equates to the lowest-fee consulting model.
One step beyond the traditional consulting model, in terms of greater involvement for external service providers, is the collaborative consulting model. Under this model, the consultant provides additional functions, typically, selection of custodian, fee negotiation with the managers and possibly cash management. The consulting firm will generally charge a higher fee for this model since it provides a greater array of functions and works to integrate or bundle a number of services into one solution.
The next step beyond collaborative consulting is the outsourcing model. Within this framework, the hired outsourcing firm can work alongside the institution’s internal staff, providing complementary expertise and technical advice for whichever functions the institution wishes to enhance, or on an ongoing basis to ensure best practices. Alternatively, an institution can outsource its entire operation, often referred to as the ‘outsourced CIO’ model, and have the outsourcing firm takeover essentially all key decision making. Within the outsourced CIO model there are any number of variants, and many types of firms ranging from consultants to manager of managers to fund of funds to former CIOs offer investment solutions.
The range of discretion that the outsourced CIO can assume varies from institution to institution as well as amongst outsourced CIO providers. In some cases, the outsourcing firm can accept some fiduciary responsibility for investment decision making, thereby relieving the institutional investor of part of its fiduciary role.
While the internal operations of asset-owning institutions have changed dramatically, over the past few years, arguably the techniques institutions use to vet managers and allocate capital has changed even more.
A traditional consulting approach often analyzed managers using a simple two-factor model: size (large-cap, mid-cap, or small cap), and style (value, growth or blend). From there a three-by-three matrix is generated, which attempts to categorize managers into one of nine style boxes. The style boxes were created by Morningstar in the early 1990s and have since become a standard tool within the industry.; however, the framework is the source of much discussion and debate regarding the accuracy of manager categorizations.
One criticism is that realistically, today’s markets are far more complex than can be captured in a nine-box style model. Product innovation, trading technologies and analytical software have given investors endless ways to slice and dice markets, so there exponentially more styles and factors. Behind each of these differing styles are differing business models, ranging from hedge funds and shadow banking entities to 40 Act funds and high-frequency trading firms. As new firms gain assets they seek alternative, differentiating angles from which to generate returns, manage risk or exploit market inefficiencies.
As these new firms and factors gain market share, it often comes at the expense of traditional factors such as large-cap or small-cap, value and growth. The decay in effectiveness of some traditional factors can be seen in the rising commonality of returns, which can be measured by correlations which show return patterns moving towards 1. U.S. large-cap and small-cap stocks are a good example of this pattern. As correlations rise, they benefits of diversification diminish and institutions end up with more eggs in one basket.
In response to increasing commonality among traditional styles, Institutional investors are increasingly vetting managers using additional categories such as quality, momentum or hold period. Other vetting techniques use sporting terminology and categorize manager styles as offense or defense. Certainly playing defense, or managing downside risk, is much easier in today’s market, as for example exchange-traded funds such as inverse equity, sector, bond or commodity funds, offer investors risk mitigation tools at a low cost with meaningful liquidity and full transparency. Such tools allow institutions to allocate capital to managers who can better manage risk exposures or more actively manage beta exposures. Institutions can also allocate capital to liquid alternative strategies that do not have notice provisions or lock-up periods.
Other institutions have allocated additional capital to tactical strategies. As market velocity rises, institutional investors can keep pace by selecting managers who follow a multi-asset or multi-style approach and can move from asset to asset or style to style as warranted. Given that the average hold for a stock in U.S. markets is seven to eight months, institutions can safely assume that short-term market movements are being driven by a greater variety of factors. Many short-term factors are non-fundamental in nature, such as technical styles including relative strength or short-term reversals. In the ultra-short term measured in seconds or less, drivers such as high-frequency trading and algorithmic styles will drive market behavior as well. While the fundamentals do win out over the long term, over the short term, the journey is generally bumpier and can results in investors receiving lower risk-adjusted returns.
As investors navigate through issues ranging from slow domestic growth, to turmoil in Crimea, to a rising regulatory tide, to the ongoing rewrite of the rules of monetary policy, institutions are likely to continue allocating to managers and styles that offer greater dimensionality beyond the traditional style boxes.