Retirement Fund - Management Selection Criteria
Manager review is a difficult process which requires the evaluation of all aspects of a firm’s organization and investment process to assess the probability that this firm will successfully meet the objectives of a given mandate going forward. Given the lack of predictive power of historical performance, performance data is only one criterion which should be considered in the selection process. Further complicating the manager review process is the fact that the weighting of criteria should differ depending upon the mandate and specific circumstances involved. For example, a fixed income manager needs to have significant quantitative capabilities to analyze all the different bond market sectors, while a small cap equity manager’s investment process would tend to be much more qualitatively oriented. Similarly, in the area of small cap investment management in which firms tend to close to new clients after gathering a certain level of assets, an investor might be willing to retain a brand new organization if the investment team was an experienced group of professionals with an outstanding track record and relatively unique investment process. Following is a summary list of factors which could lead to a manager review and/or termination as well as a more detailed list of decision criteria which should be considered in the manager selection process.
Manager Selection Criteria
I. Organizational Factors
- Stability: Has the firm been able to retain investment professionals and senior management over time?
- Ownership structure: Does the ownership structure align the employees’ interests with those of clients?
- Does the ownership structure encourage long term retention of key professionals? Are there likely to be succession issues?
- Strategic direction: Is the firm’s growth rate in assets and personnel appropriate? Is there a clear focus on investment management?
- Business viability: Are the firm’s growth prospects, assets under management and capital base sufficient to maintain a healthy business?
- Assets under management: Are assets sufficient to accommodate the University’s portfolio and, at the other extreme, has asset growth impeded the firm’s ability to add value in a given mandate?
- The University’s assets should not exceed 25% of a product’s assets under management.
- The University’s minimum portfolio size in a single product is $30 million including both the Retirement and Endowment Funds.
II. Investment Process
- Well defined: Is the investment process clearly defined and consistently applied?
- Competitive advantages: Are there any aspects to the investment process which provide a competitive advantage such as extensive information/data sources, unique modeling capabilities, unusual perspectives, depth/quality of analytical resources, and/or experience of investment professionals?
- Persistence: Is there something about the investment process that provides conviction that historical performance can be repeated?
III. Investment Professionals
- Relevant experience: Are the portfolio managers and research analysts experienced in managing this type of mandate?
- Team experience: Is there significant experience among the professionals as a team?
- Skills: Do the investment and research professionals bring complementary skills to the portfolio management process?
- Resources: Has the firm increased staff as assets under management have risen? Are the investment professionals distracted by other responsibilities including other products, firm management, sales, client service, etc.?
IV. Historical Performance
- Performance versus benchmarks: Has the firm exhibited an ability to add value to the benchmark over market cycles, typically defined as 3-5 year periods? How much value is added relative to the risk taken (i.e. risk adjusted performance)?
- Performance versus peers: Has the firm exhibited an ability to outperform peers over market cycles, typically defined as 3-5 year periods?
- Consistency: Is the level of consistency of outperformance appropriate for the mandate?
- Risk characteristics: Is the level of absolute and relative volatility appropriate given the mandate? Are the risk characteristics of the portfolio over time consistent with expectations given the mandate?
- Performance attribution: What are the sources of out or under-performance (e.g. industry bets, stock selection, style biases) and do they match the manager’s purported strengths?
- Missouri location and/or minority status: The University of Missouri has an active and ongoing interest in doing business with firms that are owned, controlled, and operated by citizens of the state of Missouri. In addition, the University is committed to supporting the participation of minority and women-owned and controlled asset management firms (as defined in Section 33.750 (3), (4), and (5), RSMo 2000) in the management of its Funds. In order to facilitate the consideration of such firms by the Finance and Audit Committee, all groups of candidates brought forward for the Committee’s consideration for investment mandates will include candidate(s) which have the above attributes whenever such a qualified candidate or candidates meet the University’s threshold manager selection criteria. The University urges firms to identify any affiliations they might have with the state of Missouri for this purpose.
- Fees: Are fees competitive?
- Fit: Fit within the overall portfolio and fit with the mandate.
- Compliance/Back office: Are compliance and back office systems adequate?
Manager Selection Process
When the Board has approved either a new mandate or the termination of an existing manager, a new manager must be selected. The Board, staff and consultant each have significant responsibilities in this process.
Working with the consultant, staff will define the criteria which will be used to select the manager candidates for the Board’s consideration. These criteria will vary by mandate and might include length of track record, assets under management, portfolio risk and return characteristics, etc. The staff will meet with a number of manager candidates which meet these criteria to select a shorter list for the Board’s consideration. No manager will be recommended for the Board’s consideration without an on-site visit by the staff.
Using databases as well as its proprietary manager rankings, the consultant will identify a “long list” of manager candidates for the staff’s consideration. The consultant will provide information and analysis for staff to use in its evaluation of these candidates.
III. Board of Curators
The Board has delegated to the Finance and Audit Committee the responsibility to select investment management firms for the Fund. The Committee will meet with those candidates identified by the staff and, based on its evaluation of the candidate’s ability to meet the objectives of the specific mandate, will select one or more of the candidates for retention by the Fund. If none of the candidates are approved for retention, the Committee will direct the staff and consultant to identify additional candidates.
Decision Criteria: Review and/or Termination of Investment Managers
Changing managers is an important decision which must balance the opportunity cost of not changing to a new manager or strategy with the transactions cost and opportunity cost of changing managers. Every manager has periods of underperformance and every investment management organization has personnel changes. The fundamental question which must be evaluated in any manager change is whether a manager’s recent underperformance or personnel change is a signal of future instability or underperformance.
The following identifies some specific factors which should trigger a review of a manager’s continued role within an investment program. Following the description of these factors is a description of the process used to review investment managers.
Manager Review Criteria
I. Organizational Factors
- Personnel changes: Virtually every organization has some level of personnel change over time. In fact, personnel change can be a positive influence on a firm, bringing new ideas and perspectives. However, the departure of professionals or the addition of new professionals who are key to either the firm’s management or the investment process should signal a need for review as to whether the original premise for retaining the firm is still in effect. In other words, are the reasons for originally anticipating competitive performance from this firm weakened, strengthened or unaffected by this change?
- Ownership changes: Ownership changes may be a positive event, for example, when ownership of founding partners is more broadly distributed to the next generation of investment professionals at the firm. However, ownership change may also be a negative event, creating dissension and departures among the firm’s professionals. In general, the firms which appear to have had the greatest success at generating organizational stability are those whose employees have a significant equity stake. In summary, any significant change in ownership should be reviewed and evaluated for its likely impact on the stability and performance of the organization going forward.
- Change in strategic direction: A firm’s change in strategic direction may be signaled by new product introductions, change in responsibilities among key personnel or change in ownership structure. Such events may indicate a lessening of focus on some of the firm’s existing investment strategies. For example, a number of firms have re-allocated existing research and portfolio management resources to new hedge fund products. This may be beneficial as a tool to retain talented employees who might be tempted lo leave the organization, but may also dilute the resources devoted to more traditional strategies.
Performance should be evaluated in two aspects, return and risk. Expectations of a manager’s performance and risk (as defined by standard deviation of returns and tracking error versus the benchmark as well as portfolio characteristics) should be defined at the time of the manager’s hiring and these expectations should be periodically reviewed for appropriateness.
- Returns: Returns should be measured against an appropriate benchmark and a well-defined peer universe. A typical expectation is that a manager will outperform their benchmark over a market cycle by level (which varies depending upon the strategy) as well as being among the top half of their peer group over that time. It is important to remember that virtually every manager, no matter how talented, will suffer some level of underperformance at times. Performance should be monitored at least quarterly and significant deviations from expectations should be closely examined for any indication that the quality or nature of the investment process has changed.
- Risk: While relative performance is typically unstable over time, the types and level of risk assumed by a manager in his or her search for relative performance is generally much more stable. In other words, managers who are much more aggressive than the benchmark (defined by high tracking error and high absolute volatility of returns) tend to maintain that level of aggressiveness over time.
- Risk can also be defined in terms of the characteristics of the manager’s portfolio, commonly known as the “style bias” of a given manager. For example, some managers attempt to generate above benchmark returns by maintaining a deeper “value” bias than the market or benchmark.
- The risk of each portfolio should be evaluated on a quarterly basis and any significant change in a manager’s risk profile or the level of risk assumed by the manager should be evaluated for its implications as to whether the manager’s investment process has fundamentally changed.
- Market changes: Capital markets are dynamic in nature and this fact may affect the ability of certain portfolio managers and investment strategies to meet expectations. For example, as markets and businesses become more global, U.S. equity managers must have an ability to evaluate U.S. businesses in the context of their global competition. Those firms which have not invested in the research resources to do so may become uncompetitive. Managers and strategies should be evaluated on an ongoing basis in terms of their ability to continue to generate incremental returns in what is an increasingly competitive market.
- Change in fund strategy: The Fund may determine that it is appropriate to alter asset allocation or invest in different strategies. Existing managers may not have the capability to meet the Fund’s changed objectives and, therefore, may be considered as candidates for termination.
- Assets under management: There are certain asset classes or investment strategies, typically strategies which have limited liquidity, in which the level of assets under management appear directly tied to the manager’s ability to generate incremental returns. The most obvious examples of such asset classes or sectors are small cap stocks and high yield bonds. Most managers in these sectors will define a maximum asset level or percentage of the market beyond which they will not take on new clients. If managers do not honor these commitments, and therefore, the manager’s ability to continue to generate expected returns is compromised, they may be considered as a candidate for termination.
- Fiduciary issues: If a manager has indicated an inability to meet their fiduciary commitments, for example, by not maintaining the portfolio within agreed upon guidelines or by not monitoring their employees adequately, the implications of this should be carefully reviewed. Investment managers are fiduciaries of plan assets and must be able to meet all the legal and administrative obligations of a fiduciary.
Manager Review Process
The staff maintains frequent and ongoing interactions with the investment managers including phone conversations and meetings, both at the University and in the managers’ offices. The staff reviews the managers’ and consultant’s quarterly reports. Should any issues or questions arise, the staff works with both the manager and the consultant to resolve such issues. When these issues or concerns are deemed material, they are brought to the attention of the Board, with recommendations regarding the appropriate course of action.
The consultant prepares quarterly analysis of investment managers’ portfolios and performance for review by the staff, and in a summary form, by the Finance and Audit Committee. It is the consultant’s responsibility to proactively identify any issues which should be considered by the Staff or Committee with regard to the managers’ continued appropriateness within the Fund’s investment programs. The consultant meets at least 2-4 times per year with each of the Fund’s investment managers. Quarterly questionnaires are obtained from the managers to ascertain whether any organizational changes have occurred at each firm.
III. Board of Curators
The Board of Curators delegates to the Finance and Audit Committee the responsibility to oversee the Fund’s investment programs. The entire Board receives quarterly performance reports. The Vice President for Finance and Administration and the Treasurer are responsible for recommending to the Finance and Audit Committee the termination of an individual manager based on the agreed upon criteria. The Finance and Audit Committee has the responsibility for reviewing the staff recommendation and for recommending to the full Board termination of a manager if it is determined that they are no longer appropriate for their role within the Funds.