THE SCIENCE AND ART OF MANAGER SELECTION

Transcription

1 THE SCIENCE AND ART OF MANAGER SELECTION Manager Research at Barclays WHITE PAPER March 2012 Wealth and Investment Management

2 Contents Introduction... 2 Overview... 3 Why Can a Manager Selection Process Matter?... 4 Different Entities Pose Different Challenges... 7 Defining What Success Means... 9 The Art: The Philosophy Guiding Our Investment Manager Selections The Science: Due Diligence in Four Parts Ongoing Monitoring and Review Sell Discipline and Termination Process Conclusion Glossary and Definitions The Science and Art of Manager Selection March

3 Introduction Dear Clients and Colleagues: In a single sentence our advice to clients is to: Design, implement, and maintain a diversified 1 portfolio that is consistent with your financial situation and your financial personality. Robert Brown Co-Head, Global Research A previous publication in this White Paper series laid out our approach to designing an asset allocation and explained why we believe most portfolios should include nine asset classes in proportions that reflect the investor s level of risk tolerance and composure. In this paper we turn our attention to the subject of implementation. Some investors may choose to invest only in self-selected individual securities: stocks, bonds, futures contracts, properties, cash instruments, etc. Much more often, however, implementing some or all of the portfolio will involve directing money to one or more professional portfolio managers who will, through an index fund, a mutual fund, a partnership, or a separate account, buy and sell individual securities on the beneficial investors behalf. For some asset classes such as Alternative Trading Strategies, there is no choice; one invests in a fund or not at all. So whether or not the managers with whom one invests do their job well goes a long way to determining how one s portfolio performs over time. Tom Lee Co-Head, Global Research Because we recognize the importance of this aspect of the investment process, here in the Wealth and Investment Management unit of Barclays we have developed a deeply considered and rigorously applied global process for evaluating individual managers. As well, we have assembled a significant team of experienced, dedicated due diligence professionals in our key offices across the globe. Through our process and our people, we identify the investment managers who, in our views, are most likely to perform well in the future. The phrase Past performance is no guarantee of future results has become a cliché of disclosure language. For us it is a core belief. We want our colleagues and clients to understand the breadth and depth of the process we go through to identify those select managers we believe warrant inclusion on our roster of approved managers. So in this White Paper, David Romhilt, one of the global leaders of this effort, articulates our approach to the science and art of manager analysis, selection, and de-selection. Sincerely yours, Robert Brown Co-Head, Global Research Tom Lee Co-Head, Global Research 1 Diversification does not protect against loss. The Science and Art of Manager Selection March

4 Overview David Romhilt Building the portfolio most likely to achieve your financial goals requires getting two things right. First you need to identify the right asset allocation, and, second, you must implement that asset allocation in the right way. For many investors, implementing an asset allocation involves hiring professional managers, either through a separate account or a fund, to build and maintain the various asset class portfolios. However, while most investors are familiar with the things that make a company s stock attractive high earnings growth potential, cheap valuation, etc. the process of manager selection is poorly understood. We all know that because a manager has performed well in the past is not a reason to believe he or she will do better than others in the future. But what does predict future performance? Here in the Wealth and Investment Management unit of Barclays, we regard manager research and selection as both a science and an art. Like science, the process should be formal, structured and repeatable to create comparative data points across institutions and asset managers. Like art, the process must be informed by a philosophy that guides our collective judgment as we integrate our objective findings in a creative way. The combination of these approaches gives us the confidence to recommend the managers we have identified to our clients. Almost inevitably, discussions about manager selection get caught up in the debate about whether investment managers in general are capable of adding value over an index 2 over time, but we are not addressing the active management versus indexing argument here. In fact, we believe there is a place for both investment management styles in portfolios, and we seek to understand each client s financial personality to determine which is the more appropriate investment strategy. 3 For those for whom active management may be suitable, this paper explains how we go about identifying, analysing, selecting and monitoring investment management organizations. 2 Manager research is also important for investors who choose to use index funds wherever possible because not all indexes or index funds are created equal. Some do an excellent job a replicating an index performance, others much less so. A discussion of this branch of manager research is beyond the scope of this paper. 3 The Wealth and Investment Management division of Barclays has developed a proprietary assessment that combines insights from the science of behavioral finance and psychology with modern theories of portfolio management to help us create an Investment Portfolio tailored to each client s financial personality and objectives. The Science and Art of Manager Selection March

5 Why Can a Manager Selection Process Matter? Historically there has been a lot of time spent on studying active manager returns versus indexes to establish whether managers can out-perform based on the average manager. It is not our intention to debate the issue of the average manager (at least not now); we are not especially interested in investing with an average manager. Our goal is to invest with some of the best managers in each investment universe, which we would typically define as top-quartile performance over a market cycle. 4 That s an important definition, one that s grounded in the empirical evidence. Historically, top quartile managers within each asset-class peer group have outperformed the respective index, despite all of the issues cited in past research around survivorship bias and other issues. That is why it is worth spending time and effort on manager selection. Figure 1 displays mutual fund excess returns (i.e., netted against the relevant index) by peer group across a number of common asset classes over the 10 years ending Barclays does not guarantee favorable investment outcomes. Nor does it provide any guarantee against investment losses. Figure 1: Net Excess Returns (%) of Top Quartile Mutual Fund Managers by Investment Style US Equity All Large Cap Funds # of Mutual Funds (Net) US Equity All Mid Cap Funds # of Mutual Funds (Net) US Equity All Small Cap Funds # of Mutual Funds (Net) International Equity All Large Cap Funds Trailing Excess Returns Calendar Year Excess Returns Rank 5 Year 10 Year Average 5th Percentile th Percentile Median ,830 1,103 2,420 2,432 2,522 2,479 2,491 2,414 2,215 2,015 1,745 1,508 2,224 5th Percentile th Percentile Median ,008 1,126 1,073 1, th Percentile th Percentile Median , ,525 1,587 1,730 1,683 1,572 1,479 1,304 1,170 1, ,393 5th Percentile th Percentile Median # of Mutual Funds (Net) Note: All the time periods longer than one year are annualized. Excess return measures the return, net of the respective mutual fund s management fees and expense ratios, relative to an index. The number of mutual funds in the study period is shown net of those who have dropped out or gone out of business. Source: Investworks.com 4 The Science and Art of Manager Selection March

6 There are a number of conclusions to draw from the data: Over the past 10 years, the 5 th and 25 th percentile managers in each asset class have outperformed (i.e., had a positive excess return) on a net of fees basis over long-term periods and in each calendar year. The degree of excess return diminishes over longer time periods, reflecting that individual managers may have generated substantial near-term outperformance, but there is often reversion to the mean over time. The average (or median ) manager s performance, even without taking into account managers who may have dropped out of the peer group (or gone out of business) is often at the index or slightly below the index. The compounding effect of these excess returns can have a meaningful impact on a client s wealth over time. Consider Figure 2, in which we map the nominal growth of $1,000,000 over 20 years assuming an annual return of 6% and assuming varying levels of excess return. The outperformance over time results in significantly more value. Figure 2: Growth of $1,000,000 Based on Various Return Assumptions $MM % Excess Return 6% Return 2% Excess Return 4% Excess Return $6.73 $4.66 $ $ Years Returns are annualized and are illustrative only. Source: Wealth and Investment Management Over 10 and 20 years the power of compounding at a higher rate is substantial, with more than a $3.5m difference in the end value based on a 10% return versus a 6% return on an initial $1m investment. Obviously this difference can work in both directions, as poor manager selection leading to a lower annual return would have the opposite impact. Past Performance Is No Guarantee If one does buy into the premise that there are managers who exist who can outperform on a long-term basis, and that this can be meaningful to the value of an overall portfolio, then can you just invest in managers who have done very well for long-term periods and expect the performance to repeat itself? This paper answers that question on many levels, but an illustration of actual manager returns can help explain why it is not as simple as relying on a manager s past performance. In Figures 3 and 4, we show data from the U.S. Large Cap and U.S. Small Cap manager peer groups published by Investworks that can be used to answer the question: do top quartile managers tend to stay there? The data represents all mutual funds still in The Science and Art of Manager Selection March

7 existence at the end of 2010 that had at least 10 years of actual past returns. The calendar year data was then grouped into pairs of contiguous 3-year and 5-year returns. For the first time period in each pair, managers were grouped into quartiles; the performance of the top quartile managers was then analyzed in the second time period. Based on this data, it s clear that top quartile managers do not tend to stay there. Figure 3: U.S. Large Cap Top Quartile Managers Subsequent Performance Investworks U.S. Large Cap All Mutual Fund Peer Group Top Quartile Performance Subsequent 3 Year Quartile Rank (Total Universe = 1046) 3 Year Ending Period Ending Period 1st 2nd 3rd 4th % 23.8% 14.6% 6.9% % 24.1% 25.3% 23.0% % 19.9% 31.0% 26.4% % 9.6% 35.2% 44.8% % 22.6% 27.2% 25.7% Average 28.0% 20.0% 26.7% 25.4% Top Quartile Subsequent 5 Year Quartile Rank (Total Universe = 1046) 5 Year Ending Period Ending Period 1st 2nd 3rd 4th % 20.7% 33.3% 29.1% Note: All the time periods longer than one year are annualized. Excess return measures the return, net of the respective mutual fund s management fees and expense ratios, relative to an index. The number of mutual funds in the study period is shown net of those who have dropped out or gone out of business. Source: Investworks.com Figure 4: U.S. Small Cap Top Quartile Managers Subsequent Performance Investworks U.S. Small Cap All Mutual Fund Peer Group Top Quartile Subsequent 3 Year Quartile Rank (Total Universe = 632) 3 Year Ending Period Ending Period 1st 2nd 3rd 4th % 29.1% 18.4% 10.1% % 10.1% 20.3% 49.4% % 20.3% 19.6% 40.5% % 25.3% 20.9% 20.9% % 23.4% 23.4% 31.6% Average 27.3% 21.6% 20.5% 30.5% Top Quartile Subsequent 5 Year Quartile Rank (Total Universe = 632) 5 Year Ending Period Ending Period 1st 2nd 3rd 4th % 27.8% 22.2% 27.8% Note: All the time periods longer than one year are annualized. Excess return measures the return, net of the respective mutual fund s management fees and expense ratios, relative to an index. The number of mutual funds in the study period is shown net of those who have dropped out or gone out of business. Source: Investworks.com Consider the Average data for the three-year periods for both Large Cap and Small Cap mutual funds; on average, only about 28% of top quartile managers in one 3-year period then remained in the top quartile in the subsequent period. The data was even worse for the 5-year periods, where 22% and 17% of the top-quartile managers stayed there. In other words, as you have read over and over again, past performance is no guarantee of future results. (While this data focuses on long-only U.S. stock mutual funds, the conclusion holds true for non-u.s. equity funds as well. The conclusion is less true for hedge funds and not applicable to Private Equity.) Despite data like that in Figures 3 and 4, performance continues to be the most important aspect of most investors decision whether to invest with a manager or not. And that is the biggest reason why most investors fail at manager selection. This paper details a different approach to the manager selection process. The Science and Art of Manager Selection March

8 Different Entities Pose Different Challenges Investment management firms and investment products come together in many different forms, each posing different challenges to a manager selection team. Despite their wide variety, the firms and products can be segmented into three categories: Traditional or long-only funds or separately managed accounts (SMAs) Hedge funds Private equity or private real estate funds These groups differ in terms of how they should be analyzed, the amount of information available, and the business terms they provide investors (see Figure 5). Figure 5: Investment Manager Classifications Characteristic Traditional (Long-Only) Hedge Funds Private Assets Ownership Varies General Partnership General Partnership Regulatory Oversight SEC None* None* Transparency Very High Mixed, Low High Publicly Available Info on Managers? Publicly Available Info on Underlying Investments? Public/Private Databases Private Databases Private Databases Yes Yes No Fees Management Fee Only Management Fee + Incentive Management Fee + Incentive above Preferred Return Liquidity Terms Generally Daily Varies, Quarterly/Annually None, 7-12 Year Time Period # of Products 25,000+ 5,000-8,000 2,500 Investment Entities Sep Acct, Mutual Fund, LP Limited Partnership Limited Partnership * There is a pending deadline for hedge funds and private equity firms of a certain size in assets to register with the SEC. Source: Wealth and Investment Management Traditional investment management is the easiest group to research. There is a wealth of information available through numerous public and private-subscription databases and other sources about managers and the components of their portfolios, which are made up of marketable public securities. The challenge is navigating all this information and organizing it in a reasonable manner, as well as ferreting out firms or information that is not be readily available to the average investor. Hedge funds are harder to study due to the lack of publicly available information. Although a number of private-subscription databases provide good not great information on hedge fund managers, they do not cover the entire investment universe. Also, hedge fund managers understandably tend to be secretive about their underlying portfolios, especially with respect to their short sales, which makes validating the The Science and Art of Manager Selection March

9 investment process more difficult. The combination of limited public information and less transparency requires manager-research analysts to conduct more manager on-site visits with hedge funds and to assemble more of the needed information themselves. Finally, publicly available information is rarest for firms that make private investments (generally private equity or real estate). Although subscription-only databases exist, they lack the breadth of data that s available in comparable databases for traditional and hedge fund investments. Further, because the investments in individual private equity funds are drawn down irregularly over long periods of time, and returns are paid out irregularly as well, it is very hard to compare return data among private managers. While managers making private investments tend to be fully transparent with what they own, the lack of publicly available data on the underlying investments themselves makes analysis or comparisons of the portfolio difficult. The Science and Art of Manager Selection March

10 Defining What Success Means Any investment process should be held accountable for the results it provides investors, and we believe it is important to articulate how we define success. In situations in which a low-cost index alternative is available, we seek to add alpha, or risk-adjusted excess returns, of greater than 2% annually to readily available indexes over a market cycle. This definition of success applies to traditional management where there is an ability to invest easily and cost-effectively in the beta (the overall market movement) of a given asset class. With hedge fund and private asset manager selection, where no simple index alternatives are available, our definition of success refers to: An absolute return target: returns should be positive over the life of the investment or over a market cycle, The return should be greater than that of the closest liquid substitute available in the public markets; for example a merger arbitrage hedge fund manager should do better in terms of risk-adjusted returns than a mutual fund that specializes in merger-related special situations, and Peer group performance: we seek to generate excess returns relative to published peer groups of other hedge fund or private equity managers who are investing in a similar manner and time period. Having a defined measure of success allows us to judge ourselves objectively and creates accountability within the research process. The Science and Art of Manager Selection March

11 The Art: The Philosophy Guiding Our Investment Manager Selections Investment management is unique in that success in this business is harder and harder to replicate going forward hence the industry s well-known disclaimer, past performance is no guarantee of future results. Why? Success generally leads to more assets under management, and as assets under management grow, the portfolio has reduced liquidity and flexibility because it owns a greater proportion of an underlying security s float. Also, as size precludes taking positions in smaller or less liquid issues, the opportunity set of investments is diminished. Thus, substantive changes in the asset base over time relative to the capacity of the asset class can make a manager s past track record less meaningful. When we analyze a manager s performance potential we aim to balance the potential disadvantages of increasing size against the advantages of dealing with large organizations, such as greater operational efficiency, more rigorous, formal risk controls, longer track-record, and so on. To analyze the impact of asset growth and size, we apply two key criteria to the organizations we evaluate. First, we believe that independent organizations that are majority employee-owned do a better job of managing asset size. These organizations tend to have a direct ownership stake in their business, more of their own money invested in their actual products and fewer points of distribution to various channels. We believe this ownership structure creates a stronger incentive to keep the asset size from getting too large. Second, prior to making an investment we seek to understand where an investment manager falls in its lifecycle. We believe the lifecycle of a manager generally follows that of a product or business (see Figure 6). When evaluating firms earlier in their lifecycle, we can be confident our incentives are properly aligned and that portfolio managers can be nimble in markets and won t be distracted by too many managerial tasks. At the same time we have to subject the firm s operations, risk controls and compliance safeguards to particular scrutiny. When evaluating larger, more mature organizations we need to pay close attention to how they avoid the inflexibility and distractions that can come with large volumes of assets under management. The Science and Art of Manager Selection March

12 Figure 6: Illustrating a Manager Lifecycle Firm Assets ($b) Relative Performance 35.0 Startup Phase Growth Phase Maturity Phase Decline Focus of Our Manager Research Firm Assets ($) Relative Performance Startup Phase Growth Phase Maturity Phase Decline Limited capital, seed capital, friends and family Limited product offering Infrastructure not solidified Investment process welldefined Key person and concentrated investment talent Success in performance or marketing Build-out of non-investment aspects Complementary products Source: Investworks.com, Wealth and Investment Management Success in flagship or multiple products At or approaching capacity Operations well-built out, hiring tends to be noninvestment Succession Planning Asset growth beyond capacity Lack of generational transfer of investment talent or equity Investment team departures More significant product lineups Strategic partnerships / ownership changes It is tempting to limit a manager search to the largest organizations. In fact the majority of managers are hired when they are mature, if not in decline. It s far easier to perform due diligence on mature organizations staffed by sophisticated marketing teams than it is to conduct research on startup or growth firms, where there are fewer quantitative measures to judge: track records are, by their nature, short and performance reporting may not be as sophisticated as that of larger organizations. Our approach, therefore, emphasizes qualitative aspects of due diligence, which allows us to identify organizations that will have longer lifecycles in our client portfolios, either because they are relatively small and have room to grow or because they have shown that they can overcome the disadvantages of size. The Science and Art of Manager Selection March

13 The Science: Due Diligence in Four Parts Our manager due diligence process can be divided into four categories, each of which carries equal weight in our evaluation: Organization attributes Investment process review Analysis of historical track record and statistics Operational due diligence With organizational attributes and operational due diligence, we have established standards of how an external investment management firm should be structured and operate, and our due diligence evaluates how well a given organization meets them. Should some aspect of a firm s organization or operations deviate from our standards, we look to see if there are any mitigating factors that may reduce the associated risk. With investment processes or historical performance statistics, by contrast, we don t have a predetermined set of standards. Evaluating the investment process is the most time-intensive and difficult component. Different firms with entirely different structures and track records can be very good investors, and it is important to remain as open as possible to reviewing each entity independently. The critical aspect is that we view the track record a firm has produced as a validation of the quality of an organization and its operations and investment process, not an indicator of a best-in-breed manager. Organizational attributes The purpose of organizational research is to understand how an investment manager is formed as a business and investment entity. The aim is to gauge the continuity of the firm and whether or not non-investment factors could possibly impact its process and ability to replicate its past performance or success. At Barclays, we believe that the organizational structure should encourage not hinder continuity in the firm s investment process. In general, we favor firms with substantial, broadly distributed ownership among employees, offering focused product lineups in portfolios of appropriate size for their markets. We discuss these aspects in greater detail below. Ownership structure: We look at a firm s current and historical ownership structure. Firms can be 100% employee-owned or majority employee-owned; they can be public companies or have parent ownership by a financial or strategic owner or an insurance company. All else held equal, we prefer firms where employee ownership is substantial and broadly distributed because we think this structure limits turnover of key investment professionals better than does any other and supports a long-term strategic perspective on the business. Employee-owned firms tend to be less sensitive to asset growth issues and better at managing their capacity, whereas all of the other structures tend to create risks to the business that could impact performance in the future. When examining a The Science and Art of Manager Selection March

14 firm owned by a parent or financial conglomerate we seek assurances that these companies will be able to retain key employees. These firms also tend to be larger by nature to justify their scale of operations, and may be less capable of properly managing capacity. We particularly scrutinize publicly owned firms, especially the larger ones. Public firms answer to two sets of clients: investors and shareholders. The interests of these two can be at odds, as shareholders look for asset growth, which can be a deterrent to future returns that investors seek. This conflict of interest may make the decision to close a product more difficult at public firms. Employee compensation structure: We review each firm s compensation practices for its key investment professionals and analysts, preferring firms that compensate key investment professionals in a manner that is competitive and in-line with our long-term performance goals and expectations. Many firms have adopted compensation schemes based on rolling multi-year performance that is in-line with their investment time horizon, and we believe this is the most appropriate method of bonus compensation. It is also critical that key investment professionals continue to be tied to the firm in terms of equity ownership and/or deferred compensation. Compensation structure is a key determinant to employee turnover, especially in competitive markets like New York, London, Hong Kong, and Singapore. Allocation of firm resources: We prefer firms that focus on a distinct or narrow area of the global market, which generally means a firm with fewer products. We think it s difficult for a firm to be good at investing across all asset classes, investment styles, and market capitalizations. A firm with a single or a few complementary products will focus its resources, whether monetary or time-related, to that product set. When evaluating a multi-strategy firm, we want to know how the company s research resources are deployed in support of portfolio managers. Assets under management versus capacity: We view excessive asset growth as a potential impediment to future returns and believe it is crucial that investment firms manage their product capacity properly. For every investment product we research, we go through an exercise to determine what we believe is a reasonable capacity for the product. The critical factors that impact capacity are arrayed in Figure 7. Figure 7: Investment Capacity Investment Styles & Portfolio Construction Portfolio Concentration Diversified # of Positions High Turnover Low Turnover Long/Short Investment Style Long-Only Investment Style Private Equity Hedge Funds Traditional Management Asset Classes Small/Micro Cap Stocks Mid/Large Cap Stocks Government Bonds Distressed Credit/Corporate Bonds Futures and Forwards Small/Mid Buyout Commodities Large Cap Buyout Venture Capital Master Limited Partnerships Real Estate Option Contracts Less Capacity More Capacity Source: Wealth and Investment Management The Science and Art of Manager Selection March

15 We create an estimate of capacity for each investment product based on these criteria and compare that number to the manager s own analysis. We are looking for managers that have a thoughtful plan in place regarding their capacity and whose estimate of their capacity is both reasonable and similar to ours. We ask the question on capacity regardless of the manager s current size, although we are more likely to get what we deem to be the right answer the further the manager is from capacity. Over time, our view on a manager s capacity may change, but any change in the manager s investment process as a result of asset growth or with the intention of increasing capacity raises a red flag. Our estimates and criteria on capacity differ according to investment style and vehicle (long-only, hedge fund, private equity). If we have any concern about a manager s size or impact on its markets, we review public disclosures around the manager s ownership of its current positions. For U.S. equities within long-only and hedge fund mandates, these are commonly known as 13-F filings. Managers with more than $100 million in assets are required to report the value of their long positions to the SEC on a quarterly basis, which we can access to review any impediment created by the manager s asset base. Our liquidity estimate for equities is a simple formula to calculate Days to Exit: Days to Exit = # of Shares Owned (Average of 3-Month Daily Volume x 20%) Long-only managers typically provide daily liquidity. Therefore, we want to be very careful that the majority of a manager s portfolio could be liquidated immediately; if any top holdings have significant days to exit, we are concerned. Hedge funds generally offer less frequent liquidity, so we can look at the Days to Exit versus the fund s liquidity terms. For example, if a fund offers quarterly liquidity with 45 days notice, we want to make sure that the fund s core positions can be easily liquidated in that timeframe without swamping the market. For non-marketable investments like private equity, the issue is not liquidity, because liquidity is offered to investors at the manager s discretion. The real issue is the impact that asset size has on the opportunity set (i.e., what a manager can buy) and the ability to create liquidity events (i.e., how hard the position will be to sell). Private investing is unique, however, in that managers are not necessarily burdened by their asset base, because they raise distinct funds. A manager may choose to raise a larger fund because he/she believes the investment opportunity is substantial, but the manager also has an ability to raise a smaller fund in the future if the opportunity set is diminished. This is in stark contrast to traditional and hedge fund managers, who have continuous funds and almost never retain discretion as to when to return capital to investors. Distribution of investment products: We also focus on the distribution channels of the manager s products. The fewer the channels, the easier it is to manage a product s asset growth. We see multiple marketing relationships, mutual fund sub-advisory relationships and consultant relationships as warning signs. The Science and Art of Manager Selection March

16 Investment Process Review We seek to answer three critical questions when conducting due diligence on any investment research process. (1) Does the manager have a special advantage in the way it picks investments arising from either the kind of information it collects or from the way it analyzes the information? We analyze the overall distinctiveness and depth of this information compared with other investment managers and publicly available information and data. We also ask ourselves how the manager s process of gathering and analyzing information is likely to lead to superior performance under various market conditions. For example, a manager that is able to develop a deep understanding of a company s supply chain might be expected to do well at times when economic growth is strong and suppliers are facing capacity limitations. (2) Has the way the manager uses the information to make investment decisions added value? It is possible an investment manager s information is identical to that of as others, but he/she may be able to zero in on important information more astutely, or develop an investment idea from the information that others may not see. (3) Have the manager s formal, explicit process, discipline and guidelines the selldiscipline or risk controls added value to the overall investment process? These guidelines can often serve as effective checks on the emotional aspects of investing; they also help ensure that the process is repeatable. All of our research on a firm s investment process is designed to answer these questions as comprehensively as possible. This is how we go about it. Review of historical holdings and exposures: This information may vary greatly based on the type of investment manager and product that we are researching. For a long-only manager, this is generally a simple data request for historical securities on a quarterly basis back to inception or at least through a full market cycle. For hedge fund managers, there may be issues with transparency or the complexity of the underlying portfolio. Where equities are involved, we can get historical information on the long portfolio through their official filings with the SEC. For other types of securities we rely on information provided by the manager that we can verify through various measures. Hedge fund managers tend to be more secretive regarding their investments on the short side, but we can obtain overall levels of exposures and historical information. For private equity, we can get all of the historical positions, but because the securities are not marketable, it is much more difficult to get relevant information about the underlying holdings and pricing. In all cases, we are seeking to confirm that our understanding of the manager s investment process correlates with what has actually been owned in the portfolio. This analysis serves as the basis for many of our questions to the manager to assess information, judgment and portfolio construction. Historical performance attribution: Performance attribution generally leverages the same data and information as the review of the historical holdings and exposures, but here we try to recreate the manager s performance over time. We need to understand how a manager has driven performance, so we can explain the track record and assess whether it is consistent with how we view the organization and is replicable. For a long-only manager, we look at the individual holdings and analyze the contribution of each security to performance, as well as the contribution of each sector and of cash holdings. This allows us The Science and Art of Manager Selection March

17 to assess the consistency of the results and what has driven performance over a distinct period (we typically look at calendar years). For hedge funds, we generally look at the long positions or at key contributors to the performance of a given period, such as the top 10 contributors and detractors. For private investments we look at each investment that is made as part of a particular fund and how that investment contributed to overall results. We also evaluate the individual internal rate of return (IRR) and the multiple of capital that the investment generated. We look at how individual securities impacted performance, checking for consistency of decision-making, and we seek to verify that the track record has been created in a manner that is consistent with our understanding of the investment process. What we want to know is whether the manager s historical performance is attributable to a small number of very big winners or to a high proportion of moderately profitable investments. The latter pattern is more likely to be replicable in the future. Return gap analysis: This provides insight into whether a manager has added value over a given time period and is generally applicable only to equity managers where we have fairly full transparency into the portfolios. In effect, we begin each year (or any other time period) with the manager s actual portfolio and calculate the performance of that portfolio if it were held static and then compare that static return to the actual return the manager generated over that same time period. By linking a number of distinct time periods together, we can ascertain whether the manager s process adds value over time. Active share analysis: We start with a manager s portfolio at a point in time (and once again, this really works only with equity managers) and focus on whether a manager s portfolio is significantly different enough from a given benchmark to provide an opportunity to outperform an index fund by enough to compensate for the difference in management fees. Review of portfolio construction: Here the focus is on making sure that the portfolio has met certain guidelines over time on a consistent basis. The guidelines may have been established by the manager, such as a cap on residual cash exposure, leverage or relative sector weightings. Or they may relate to one of our own criteria, such as our belief that active managers generally need fairly concentrated portfolios in order to outperform. Analyzing data such as the number of holdings, the concentration in the top 10 positions, the overall leverage, gross/net exposures and the cash weighting at various points in time, the review focuses on verifying that the various characteristics have been consistent over time and that the process is replicable in the future. Any substantive change in these factors could call into question the replicability of past results. Sell discipline: Having a viable exit strategy should be a key component of every manager s investment process, and we pay particular attention to how securities are sold from the portfolio. The decision to exit a security can be just as important as the original purchase and may be more challenging for a portfolio manager due to emotional attachment to a particular investment or the added layer of tax consequences 5 and other transaction costs. We review the manager s stated criteria for sales and compare these with the actual securities they have sold. We are looking for consistency and accountability for these decisions. 5 Neither Wealth and Investment Management nor its employees renders tax or legal advice. Please consult with your accountant, tax advisor, and/or attorney for advice concerning your particular circumstances. The Science and Art of Manager Selection March

18 On-site review with the portfolio manager and team: These meetings are the culmination of all the work we perform on a manager s investment process. They involve a review of all of the questions that arise from the analysis outlined above, in addition to an overall assessment of the quality of the investment process, the investment team and the efficiency of the markets that the manager trades. At a minimum, this process involves a lengthy meeting at the manager s offices, although it often requires multiple on-sites and conference calls to complete. Analysis of Historical Track Record and Performance Statistics Every investment organization has produced some sort of historical performance track record over a given time period, whether it s just a month or 20 years or more. While a track record is an important aspect of the overall analysis, it represents what an organization has done in the past, and we are much more interested in ascertaining what an organization is likely to do in the future. We review quantitative data over rolling periods that are consistent with our view of the manager s investment time horizon, typically between one and five years. Rolling periods tend to smooth out the results so that short periods of substantial out- or underperformance are not given undue weight, providing a good perspective on consistency of results. Performance and statistical analysis versus indexes and peers: With long-only managers, we isolate the relevant rolling period that matches a manager s investment time horizon and focus on the manager s excess returns 6, alpha, beta, standard deviation, Sharpe ratio, information ratio, risk/reward, up/down capture ratio, profitability, consistency ratios and correlation, comparing these statistics to the market benchmark that best represents the manager s investment universe. Whether the manager made or lost money over time is important to us, but to a large degree, our main gauge of long-only managers is in relation to the relevant market index. This is why we accept some level of volatility and drawdown with long-only managers. But with hedge fund returns, we analyze the return stream using shorter rolling time periods to match shorter manager investment time horizons, and we focus on absolute returns, standard deviation, Sharpe ratio and profitability. Here our comparison evolves to an absolute level of return or return in excess of cash, although we also make evaluations versus peer groups of other similar hedge fund managers. Risk statistics: We analyze risk in two ways: The consistency of volatility and risk-taking over time, and The magnitude of the largest drawdown. When comparing long-only managers with relevant market indexes, we look for consistent levels of correlation with the market and of return volatility relative to the benchmark over time. Of course, absolute levels of volatility in the market will change over time, but we want to see that a manager s positioning versus the market is fairly stable; a defensive manager s returns should be consistently less volatile than market returns, for example. In addition, we look at what was happening in the market during individual periods of drawdown and how well the losses were recovered relative to the market. With hedge fund managers, the analysis of the risk-taking is more absolute; 6 See the Glossary for definitions of these and other terms. The Science and Art of Manager Selection March

19 we want to see consistent levels of volatility over time. We pay particular attention to a hedge fund manager s drawdowns the reasons for the loss and how the managers reacted. Drawdowns can be particularly difficult for hedge fund managers given their compensation structures (incentive fees as a percentage of positive performance) and the impact losses can have on capital outflows from the fund. Performance statistics versus assets under management growth: As outlined above, we think the size of a manager s asset base can have a critical impact on performance with bigger not necessarily better (or worse). To make sure that as the manager s asset base has grown, the quality or nature of the manager s track record has remained consistent, we compare excess returns, standard deviation, alpha and profitability with growth of assets over time. Tax efficiency (if applicable based on tax status and jurisdiction): An understanding of after-tax returns for each manager can be critical for taxable investors. We take both a qualitative and quantitative approach to assessing overall tax-efficiency. For each manager, we estimate the percentage of the overall return that is likely to be generated from long-term capital gains, short-term capital gains, interest and dividends, taxexempt income, short sales, futures and leverage, each of which may have particular tax consequences, depending on the jurisdiction. For hedge fund managers we can review historical tax filings to determine how gains were classified. 7 Private equity and real estate returns: Analyzing returns of non-marketable asset classes like private equity and real estate is as complicated as it is important to an overall manager research process. Because returns are based in dollar-weighted internal rates of return as opposed to the widely accepted time-weighted rate of return in the long-only and hedge fund community, return analysis is more challenging. Dollar-weighted returns effectively mean that a manager s decisions over the timing of capital calls, the deployment of capital, and the return of capital, are all significant components of the quality of the return. The overall return generated and the multiple of capital returned are both essential components of the return. Dollar-weighted returns can be overstated if a small gain was generated in a very short time period, which is why using the overall multiple of capital contributed by investors is critical. Further, there are no simple comparisons for non-marketable managers. The industry generally uses peer groups of other similar investments in private assets to arrive at a comparable universe. But not only do you have to line up the investment universe, you also have to find managers who were deploying capital in similar time periods the investment s vintage year. Thus, to perform a reasonable analysis of a private equity manager, you d have to compare both the IRR and multiple of capital generated to a universe of similar investment mandates, with similar investment time periods. Despite its complexity, it s important to do this analysis of a private equity or real estate manager s previous funds because nonmarketable investment managers have, for the most part, done a better job than other types of investment managers of replicating past strong performance in future investments. So identifying top-quartile performance is all the more critical when dealing with this group of managers. 7 Neither Wealth and Investment Management nor its employees renders tax or legal advice. Please consult with your accountant, tax advisor, and/or attorney for advice concerning your particular circumstances. The Science and Art of Manager Selection March

20 Operational Due Diligence The goal of an operational due diligence (ODD) process is to analyze and mitigate the non-investment risks associated with any investment in an external asset management organization. We examine and monitor the operations of all of the investment managers we recommend to our clients, but the most detailed ODD process focuses on hedge funds. These vehicles pose the most obvious non-investment risks to our clients: the funds are private placements; they have an overall lack of transparency; each fund deals with multiple transaction counterparties and numerous external vendors; and hedge funds have been shut down for fraud and operational problems. Our ODD process focuses on four critical steps in coordination with the investment team. Document and Legal Review: All private placements in the form of a limited partnership (LP) are required to have a private placement memorandum (PPM), limited partnership agreement (LPA) and subscription documents. These documents provide extensive information about the offering, its investment guidelines and its terms, all of which need to be reviewed. In addition, except for newly-created entities, LPs will have audited financial statements, which provide information about past performance, financial instruments used, asset valuation practices, and comments from the auditor. Verification of External Relationships and Vendors: Firms that offer LPs in a hedge fund format generally have numerous external vendors, including an auditor, an administrator, a custodian and a brokerage relationship, all of which must be verified and reviewed to confirm that the relationship does exist as the manager has stated and that the level of service being provided meets the standard we expect. Sometimes certain services such as administration or custody are handled internally or by a related party. At Barclays, we believe independent external auditors, administrators, custodians and brokers are critical to ensuring that no conflicts of interest exist and that non-investment risk is minimized. Background Checks: We hire external vendors to perform background checks on a fund s key personnel, including investment professionals, senior employees and anyone with discretion to transfer capital. The background checks provide verification of an employee s biographical details (such as education and employment), search court records, civil findings and media records, confirm property records and analyze regulatory bodies for any adverse findings. On-Site Visit: Similar to the investment due diligence, an on-site visit is a critical final part of any rigorous ODD process; it allows us to spend significant time with the Chief Financial and Operating Officers and other senior members of the firm, and any issues raised by the first three parts of the process can be resolved. A typical on-site visit involves a discussion of how the fund evaluates illiquid holdings, and manages counterparty credit exposures. We also review external vendor relationships, the organizational structure, internal administrative and accounting functions, compliance procedures, trading operations. The Science and Art of Manager Selection March