Don Ezra
Don Ezra
Knowing Your Investment Manager
Probe beneath a manager’s performance: Is it likely to continue and will business and compliance risks derail the manager?

March 17, 2011
by Don Ezra

Why bother with active management at all? Why not simply invest in a series of cap-weighted asset class indices? That way you can satisfy your asset allocation strategy, save money (index funds are less expensive than actively managed funds) and align with modern portfolio theory (in which the aggregate market portfolio has a prime role). Indeed, that’s the natural starting point and departures need to be justified explicitly by one of three reasons:

  1. There may be no readily replicable index, as for example with private equity and private real estate.
  2. Your objectives may not align with a passive index (for example, you may want to match a series of cash flows, in which case the bond market index is irrelevant to your purpose); or you may believe cap-weighting to be inefficient: fundamentally-based indices are one example of an approach that deliberately eschews cap-weighting.
  3. You may believe that you can outperform a cap-weighted index. This could be prompted by the belief that alpha-seeking managers as a whole have a tail wind, through opportunities like initial public offering (IPOs) that aren’t generally available or by providing liquidity to markets when it is scarce; or because you believe you have skill in identifying superior managers (in which case you should surely test your success periodically).

These reasons vary from one country to another and from one asset class to another and over time: there’s no constant superiority of either active or passive. And even when you establish a reason for pursuing active management, you still need to access your preferred alternative, at a cost below the expected benefit.

Traditionally, finding a superior active manager has relied on “the four Ps”:

  • Start with identifying the people involved. Who are they, how do they interact, have they worked together before?
  • What’s the process they use that you believe gives them a competitive advantage?
  • Check the portfolios they held from time to time. Are they consistent with your understanding of their stated approach? If not, you probably don’t understand their process or they have changed it, making their history irrelevant.
  • Only then is it worth bothering to check if their past performance is consistent with their process and your presumption of skill. If you start with performance, you’re simply data-mining and will probably end up buying high and selling low.

The latest development in manager research is to check on their compliance and operations. This tends to fall under three headings:

  1. Business risks, like the basic structure of the business, its governance, management oversight, third-party vendors. What sort of growth has there been and how has that growth changed their governance and oversight structure? Infrastructure, IT and business continuity and recovery plans would also come under this heading.
  2. Trading and operations risks, like execution, soft dollars, management of counterparty risks, monitoring trades, catching errors, settlements and reconciliation, how securities are priced, whether performance calculations are consistent. How much of this is automated and how much is manual? Think of Baring’s Bank in 1995 and Nick Leeson and Jerome Kerviel at Société Générale in 2008. Not having proper oversight can be fatal to a manager.
  3. Check compliance risks: not just the actual monitoring of compliance, but even the compliance culture. And are there regulatory issues? How are they dealt with? How are conflicts of interest handled? What about the approach to employee activity? Is the code of ethics taken seriously or a joke?

At Russell we give a firm an overall rating after an investigation of this sort. The rating has four categories:

  • Satisfactory, when all the important aspects seem effectively done;
  • Monitor, when there’s something identified that requires specific action;
  • Weak, when there are aspects that need improvement; and
  • Deficient, which speaks for itself.

That last category will typically relate to a small operation, like a boutique manager or a husband-and-wife operation.

We always tell the manager about our findings (not the whole report itself). Partly this is to ensure that we haven’t misunderstood something. But partly it also serves an educational function for the manager, who becomes aware of our evaluation standards or even worse, becomes aware of something in the firm that needs correction — often we’re there before the regulator gets there. And certainly from Russell’s perspective, if there are things to be fixed, no money over which Russell has discretionary placement authority will go to that manager until it’s fixed.

We find that regulators in the United States (U.S.), the United Kingdom’s (U.K.) Financial Services Authority, Australia’s Securities and Investments Commission, the Ontario Securities Commission (there isn’t a national system in Canada and not all provinces have equal capabilities) — investment firms under their jurisdiction are subject to a regulatory culture that we find helpful. It’s in emerging markets and emerging economies and with small firms everywhere, that you know the potential for problems is greatest.

The interesting thing, though, is that large American firms have operations there, so there’s the definite potential for issues in global operations.

With mergers and acquisitions, even in the U.S. you find firms with different systems: which one will the combined firm go with and how many experienced operations managers leave?

Perhaps this gives you a feeling for why these reviews are now supplementary to investment skills reviews, why they’re conducted by a different team with a different mind-set and why there’s an increasing demand for this sort of review.

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Don Ezra is co-chair, global consulting at Russell Investments and a 27-year Russell veteran and an award-winning author. Most recently he co-authored: The Retirement Plan Solution: the Reinvention of Defined Contribution (John Wiley, 2009).

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. USI-9045