As a fiduciary, selecting and monitoring investment managers is an important part of the investment process and prudent management of an endowment or foundation portfolio. This process requires a great deal of care and diligence to ensure the pool of assets is able to meet the long-term goals and objectives of the organization it is meant to support. An investor can carry out a rigorous process for selecting the optimal asset allocation for their portfolio, however, if the selected investment managers consistently fall short of expectations and fail to produce adequate risk-adjusted returns, the portfolio will have a difficult time meeting the needs of the organization in the long run.
At Trust Point, we believe that risk control is central to long-term investment success. Trust Point pays close attention to relative portfolio volatility, benchmark tracking error, and downside portfolio protection. In addition, a manager’s qualitative factors like tenure, firm stability, fees and alignment of interests influence investment decisions.
A typical manager selection process resembles the following process.
Manager Selection Process
Initial Screening
The first step in any manager selection process is an initial screen to help narrow the list of potential candidates within the investment universe. An important decision on the initial screen is whether to select an active or passive manager. At Trust Point, we believe in selecting active managers in asset classes where the benchmark regularly falls near or below the median active manager and the magnitude of active management outperformance has the potential to be meaningful. In asset classes where there is lower probability of outperformance and the potential reward for selecting a good active manager is low, we recommend utilizing a low-cost index fund that closely follows the benchmark. This provides a higher probability of providing excess returns from the asset classes.
Once the active versus passive decision is made, other initial screens may include manager tenure, AUM size, investment vehicle options, and/or any liquidity provisions or requirements potentially contained in an Investment Policy Statement.
The manager selection process also involves doing a high-level qualitative review of the prospective investment strategies that pass the initial screen. This includes a review of both the firm and the specific strategy under review. Qualitative items to consider consist of the following:
- Firm’s overall philosophy to investing
- Depth, knowledge and expertise of the portfolio management teams
- Growth and stability of the firm
- Repeatability of the investment process that aligns with the firm’s philosophy
If the firm and strategy remain compelling as a potential fit for investment, they move on to the next stage in the process.
Due Diligence
Once a strategy makes it to this stage of the selection process, Trust Point sends a detailed due diligence questionnaire to the manager. This questionnaire includes further qualitative and quantitative questions that help us understand the finer points of the manager’s people, process, philosophy and historical performance.
- Attribution of performance (what are the key drivers of returns?)
- Capture ratios (how does a manager perform in “up” markets versus “down” markets?)
- Historical drawdowns (when a manager suffers negative performance, what is the magnitude and duration of these periods?)
If a manager continues to look favorable after reviewing the responses to the questionnaire, they move on to the final part of the selection process.
Analysis and Recommendation:
Next, it’s important to address any unanswered questions or concerns that arise when reviewing the due diligence questionnaire. Once a thorough analysis is completed, a recommendation can be made.
“Deep-Dive” Review
Finally, managers that reach the final stage of the selection process should undergo a deep-dive research process. This includes on-site interviews that examine the manager’s buy/sell process, portfolio construction methodology and compliance. Operational due diligence is also included in this step. Operational due diligence includes a review of topics like key service providers – for example, audit services, legal counsel, and custodian, to name a few – stability of the leadership team, back-office operations, cybersecurity, insider trading policies and alignment of incentives. This final step of the selection process helps narrow out managers that may not be the right fit for the needs of the endowment’s portfolio.
Only after a thorough selection process should a manager be considered for investment. Consistently following this type of process can help ensure that the best managers rise to the top of the list for possible implementation in an organization’s portfolio.
Ongoing Monitoring and Evaluation
Once a manager is selected for investment, the work does not stop there. The final key piece of manager selection is ongoing monitoring and evaluation. Periodic review of the investment strategy is necessary. After all, as an investor, it is important to make sure that the manager continues to execute as expected.
Reviewing manager performance requires more than just comparing the manager’s return versus the appropriate benchmark. It is critical to understand what the drivers of underperformance or outperformance are. We need to understand not just what happened, but why it happened and what it means? Was the investment manager’s style out of favor during the period being reviewed? Did the manager deviate from their process and philosophy outside of their area of expertise in an effort to “chase” returns? These types of questions help provide context for a deeper understanding of the source of returns.
Lastly, it is imperative that investors remain patient during periods of underperformance from active managers – barring any other significant qualitative reasons (senior portfolio manager retires, leaving behind a team with significantly less experience, for example) – and not hastily make a decision to fire a manager. Often, top-quartile managers face adversity along the way. A recent 10-year review shows that 92% of top quartile managers over a ten-year period experience at least one three-year period where their results fall into the bottom half of their peer group.
While decisions to terminate one manager in favor of another are never easy, they should also follow a clearly defined process that takes into account changes in both qualitative and quantitative factors that may have changed since the incumbent manager was initially added to the portfolio.
Having a consistent process in place to review, approve and monitor the investment managers in your organization’s portfolio is part of a prudent governance process and will aid in the long-term success of the portfolio.
For more information on how we select and monitor investment managers, please contact any of the professionals at Trust Point.
