Selecting the Managers: Research and Due Diligence

Transcription

1 Selecting the Managers: Research and Due Diligence January 2014 Scott Lavelle, CFA, FRM, CAIA Director of Investment Advisor Research/Structured Products Introduction Having choices can be good. Having too many choices can be daunting. Having someone to help you navigate through myriad choices can mean the difference between making a decision and making a good decision. At PNC, we want to help you make sense of all of the investment choices you face between mutual funds and exchange-traded funds, customized portfolios and separately managed accounts, and hedge funds and other alternative investments. We also know that finding the right managers within each of these choices is challenging, yet the decisions can affect your long-term financial wellbeing. For that reason, PNC established the Investment Advisor Research (IAR) group. Investment performance data on money managers is readily available, but it takes time and expertise to critically evaluate and identify the investment managers that most effectively satisfy specific financial objectives. Thousands of investment managers are registered with state and federal regulatory agencies, making it extremely challenging to identify exceptional managers. Confronted with such numerous options, many investors typically focus on past performance as the sole determinant when selecting an investment manager, often overemphasizing recent performance. In order to distinguish exceptional managers from the crowd, the IAR group does not depend solely on review of past investment performance. Rather, we employ an approach that evaluates both quantitative and qualitative factors that we believe are critical to identifying the potential of an investment manager over time. The team does not rely on a synthetic performance-based rating methodology we believe that would have little merit or success in predicting future performance behavior. Rather, IAR has identified five different areas of an organization that we believe will help us select high-quality investment management firms that can deliver superior future results within their specific areas of expertise. It is important to note that these five areas are not mutually exclusive, but rather are interconnected. We seek firms that display positive attributes in all of these areas: pnc.com/institutionalinsights

2 Selecting Managers Price-to-earnings (P/E) ratios A portfolio s P/E projections generally provide insight into a manager s sensitivity to valuation. Historically viewed, P/E indicates how aggressive or conservative a portfolio manager has been. Price-to-book ratio At a portfolio level, similar to reviewing P/E ratios, this measure generally provides insight into a portfolio manager s sensitivity to valuation over time. Portfolios with high price-to-book ratios tend to be less concerned with value, possibly indicating a growth bias over time. Price-to-cash-flow ratio Many analysts view cash flow as the ultimate test of financial health. Portfolios with high price-to-cash flow ratios may typically invest in companies that may not generate substantial positive cash flow over time. This measure may indicate the overall quality of a portfolio. Dividend yield the dividend divided by the share price, measures how much yield a portfolio has generated over time. It can indicate whether a manager has been more or less conservative than its peers or benchmark. Beta measures the movement of the performance of a particular portfolio compared with the movement of an assigned benchmark. If a portfolio has a beta greater than 1, it is regarded as more risky. Standard Deviation measures average deviation of a return from the mean and is often used as a measure of risk. A large standard deviation implies large swings in returns for a manager. Historical standard deviation helps us evaluate how aggressive a manager has been. Tracking error is the annualized standard deviation of monthly or quarterly differences between portfolio returns and their benchmarks. A higher tracking error means the portfolio behaves less like the benchmark and vice versa. investment professionals; consistent investment process; strategy performance; business and operational structure; and legal and compliance. Evaluating Investment Professionals Evaluating the capabilities of investment professionals is the most important, yet most subjective, area within the evaluation process. IAR seeks to methodically evaluate investment professionals. Multiple conversations are required in order to gain an overall comfort level prior to hiring them for our clients. Our conversations typically focus on: the individual(s) responsible for the management of a specific strategy; the overall depth and experience of the investment team; years of investment experience; key investment professional tenure with the organization; educational backgrounds and related credentials; depth of knowledge of the portfolio; the team and organization s stability over time; and team dynamics. When evaluating the investment professionals of an organization, it is very important to identify the individuals who are critical to a firm or to the management of a particular strategy. We do not always view professional turnover as negative. At times, turnover is problematic if it is believed that a key individual has left a firm. In other instances, the departure of a portfolio manager, research analyst, or even someone from the executive level may be a positive event for an organization if that person did not add to the success of a strategy or firm. Overall, however, the Investment Advisor Research team places a premium on stable organizations with experienced investment professionals who have demonstrated an ability to navigate through both bull and bear market environments. We expect portfolio managers to display a solid command of positions held in portfolios while providing insights into how they are positioning the portfolio for future success. In addition, we expect the research analysts who support the portfolio managers to know intimately their respective industries of expertise and to be cognizant of larger industry trends that may positively or adversely affect the companies that comprise them. Consistent Investment Process IAR requires that investment managers adhere to their stated investment process over time. The reasons for this are twofold. PNC believes asset allocation is vital for clients to meet their long-term financial objectives. If a manager migrates from its stated investment discipline, the repercussions could be significant and could reduce the likelihood of clients achieving their long- term financial goals. 2 January 2014

3 Research and Due Diligence The consistent implementation of a clearly articulated investment process makes the evaluation of past performance more meaningful and gives a greater degree of confidence in the ability of the process to repeatedly provide such performance. An inconsistent investment process gives investors little ability to develop reasonable performance expectations. Overall, investment managers seek to add value in different ways in an attempt to distinguish themselves from other managers of investments within the same asset class. Some managers may seek to take on more active risk than others do in order to achieve their return objectives, whereas other managers may seek smaller active risk exposures within a portfolio. The IAR group works to fully understand how a manager seeks to add value over time and to effectively evaluate a firm s stated and implemented investment process against its performance and its portfolio characteristics. In order to determine the consistency of a stated investment process over time, IAR examines several factors. Portfolio Characteristics Are portfolio characteristics consistent with the stated investment philosophy relative to an appropriate benchmark? Some of specific items we review include: historical and forecast price-to-earnings ratios; price-to-book; price-to-cash flow; dividend yield; beta; historical standard deviation; and experienced tracking error. Stated Portfolio Risk Guidelines Has the manager adhered to portfolio risk guidelines over time? To determine this, we review the portfolio s: economic sector exposures; industry exposures; absolute position sizes; and cash positions. Portfolio Attribution Is the value added or portfolio underperformance the result of informed decisions or of market and economic forces independent of the team s investment strategy? The Treatment of Accounts Within the Same Mandate Are there differences between the management of institutional accounts versus a mutual fund? Are clients, regardless of account size, given the same access to an investment team s best ideas? 3

4 Selecting Managers Self-Checks Do the portfolio managers critically evaluate their performance over time? Do they constantly re-evaluate themselves to ensure that clients receive the best possible portfolio? Strategy Performance Investment performance is an investment manager s end product. Performance is the result of a firm s philosophy and the firm s investment professionals implementation of their investment process. In order to effectively evaluate a manager s performance, PNC s Investment Advisor Research group has developed a comprehensive framework to assess the level of success a manager has experienced and may experience over time. This methodology does not simply review a performance figure at a point in time to judge success, but rather incorporates a multidimensional approach. It is our belief that this multidimensional approach will provide a comprehensive perspective that will enable us to properly evaluate performance over the long term. First, we establish performance expectations for each investment option available through PNC. Appropriate performance expectations can be established only with a full understanding of an investment manager s investment philosophy and a portfolio manager s investment biases. Once this is accomplished, reasonable performance expectations can be created and results can be properly measured. To achieve this goal, PNC has stratified its universe within the equity, fixed income, and fund of hedge fund categories to appropriately classify managers and assign what we believe are the most accurate benchmarks for performance comparisons. For example, PNC segments U.S. equities into seven distinct categories across the market capitalization spectrum; while in fixed income, four different maturity classifications have been established, with an additional focus on duration management and tax status. Second, once managers have been properly classified, a rigorous portfolio performance review is conducted and measured against benchmarks, peers, and our own performance expectations. Investment performance is also placed into both shorter- and longer-term contexts. We prefer to analyze performance over rolling five-year periods, which generally incorporate both bull and bear market environments. Rolling one-year time periods are reviewed, as well, to highlight potential performance warning signs. In addition, other metrics are reviewed to incorporate the analysis of risk in relation to return. Overall, the goal of this endeavor is to disaggregate investment performance to separate skill from luck and to ensure that intended actions are driving performance. Last, we seek other information in order to establish a high degree of confidence in the integrity of a manager s investment performance. Is a manager s investment style in or out of favor? Does the manager fall heavily out of favor over time, only to make it up in certain types of market environments? Is the manager more benchmark-conscious, taking few active positions away from the index (possibly leading to low tracking error), or is the manager benchmark-impartial, looking to generate solid, absolute results with little concern for active bets relative to an index (possibly leading to high tracking error)? Has the portfolio remained consistent over the life of the product? Are the individuals who manage the portfolio today responsible for historical performance? 4 January 2014

5 Research and Due Diligence Has stock selection added value over the longer term? Has sector selection added value over the longer term? How has the manager performed in up and down market environments? Has the manager engaged in style drift over time to capture good performance? Has the manager changed the stated benchmark over time to appear more competitive? Has the manager s performance composite been audited? How is the composite calculated? What types of accounts are excluded from the composite? Is cash included in the composite? Business and Operational Structure We believe a good ownership and operational structure is necessary to provide the best investment teams with the potential for lasting success. As a result, PNC s Investment Advisor Research team places emphasis on the quality of an organization s overall business configuration. We strive to find investment management firms that properly align their interests with those of our clients, as well as those that have a well-designed operational infrastructure that allows for investment professionals to maximize their expertise. In addition, it is critical for firms to provide a compelling incentive and operational structure to recruit and retain talent in today s highly competitive investment marketplace. Firms that cannot capitalize on their business makeup to ensure long-term success are likely to eventually fall along the wayside. In order to find firms that we believe align their interests with our clients, numerous questions are asked, some of which are outlined below. What is the overall ownership structure of the organization? Is ownership concentrated or broadly distributed? How are investment professionals and other key members of the organization compensated? Do individuals receive equity ownership? Do the portfolio managers or research analysts have personal stakes within their portfolios? Does the firm require this? Has the firm experienced a high degree of personnel turnover? Is there a clear succession plan in place for the second or third generation of investment professionals? Has asset growth been explosive, stable, or in rapid decline? What are the firm s future growth plans? Is the firm s strategy focused and well articulated? Legal and Compliance In today s environment, dominated by litigation and regulatory constraints, it is imperative that firms have well-documented policies and procedures to guide fair, ethical, and equitable treatment of clients. We gravitate toward firms that have not experienced any adverse legal or regulatory actions. A firm that has experienced significant regulatory or legal action typically is an organization with lax controls that may be vulnerable to other legal or regulatory violations. On the other hand, there may be otherwise attractive investment management firms that have encountered limited legal and regulatory issues in the past. If this is the case, the firm must demonstrate that these issues have been fully resolved 5

6 Selecting Managers and that the proper controls have been implemented to prevent a recurrence of equivalent or similar events before we place our confidence in the firm. As part of our due diligence process, the PNC IAR team will review an investment management firm s ADV Parts I and II (the forms used by investment advisors to register with the Securities and Exchange Commission (SEC) and state securities authorities) before making the manager available to our clients. In addition, and in the cases where a firm may not be required to file an ADV form with the SEC, we will have detailed conversations with managers regarding historical legal or regulatory issues, their nature, and to what extent the managers are involved in pending lawsuits (if any). In order to gain a greater comfort level, we typically ask several key questions, including the following. What has been the extent of any legal or compliance issues? If infractions occurred, did they involve key members of the organization? If so, to what extent? If past infractions occurred, what were the penalties for the individuals that engaged in the activity? What was the date of the manager s last SEC or state examination? Were any material deficiencies uncovered? What are the policies and procedures regarding trading? How does the firm ensure and measure best trade execution for clients? Do personal securities trading policies exist? What types of insurance is carried by a firm? Is it sufficient? Does the firm maintain a Code of Ethics for employees? Manager Selection Once we have identified what we believe to be attractive candidates through our qualitative and quantitative process, a PNC investment committee then subjects managers to a formal review. During this evaluation, we scrutinize the rationale behind an investment recommendation. The committee may raise questions that were not previously addressed, and all committee members are given the opportunity to express any concerns. Once all outstanding issues have been resolved, the committee decides to accept or reject the given recommendation. It is important to note that at PNC, in order to provide consistency in decisionmaking for our clients, one investment committee deliberates on all investment options considered for our different product platforms. Ongoing Monitoring We employ a comprehensive, ongoing monitoring process in order to determine whether investment managers continue to meet our standards. To accomplish this objective, PNC s Investment Advisor Research team evaluates managers in two ways on a continuing basis. First, the team engages in a thorough review process. Each investment option residing on our mutual fund, separately managed account, and alternativeinvestment platforms is reviewed for both shorter- and longer-term performance trends relative to benchmarks and peers. Given our classification system of investment options, this process enables us to uncover any potential issues from a performance perspective sooner, rather than later. 6 January 2014

7 Research and Due Diligence Second, we conduct a more formal review every months in order to determine whether any major changes have been made to the team, the investment process, or the organization. To accomplish this, we have direct conversations with key investment and client service professionals to determine whether our high degree of confidence in a manager remains warranted. Potential Issues Periodically, we must scrutinize managers that encounter difficult situations. Given that not all circumstances are identical, IAR has created different warnings to alert PNC investment advisors to potential problems versus issues that require immediate attention. When difficult situations arise, PNC may place an investment option on Watch, Hold, or Sell status depending on the severity of the concern. Generally, managers will be placed on Watch, Hold, or Sell when: key investment personnel depart; a strategy is experiencing unexplainable difficult performance over an extended period; ownership structure changes; the investment process is altered; or style drifts. Protecting client assets is paramount. Our goal is to make timely, well-founded investment decisions that consider all relevant information in order to draw the best possible conclusions for our clients. Conclusion While PNC, like other investment managers, does not guarantee the investments of its clients, PNC believes that it is important to carefully review the investment options that we make available. PNC offers clients access to highly skilled, experienced specialists to help navigate the broad universe of investment options in order to arrive at customized solutions to help meet the risk and return objectives of clients over time. In order to continue to provide our clients with what we believe to be prudent investment management vehicles, PNC engages in a consistent decision-making process that includes a rigorous, ongoing evaluation of existing investment options and an active search for new ideas. With these capabilities, PNC believes that we have continued to strengthen our value proposition and have increased our ability to become a total investment solution for our clients. We commit to be your trusted advisor the first place you turn for advice and solutions. 7

8 Selecting Managers R The PNC Financial Services Group, Inc. ( PNC ) uses the marketing names PNC Institutional Asset Management SM for the various discretionary and non-discretionary institutional investment activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and investment management activities conducted by PNC Capital Advisors, LLC, a registered investment adviser ( PNC Capital Advisors ). PNC Bank uses the marketing names PNC Retirement Solutions SM and Vested Interest to provide non-discretionary defined contribution plan services and PNC Institutional Advisory Solutions SM to provide discretionary investment Use of management, these materials trustee, is dependent and other upon related the judgment services. and Standalone analysis custody, applied by escrow, duly authorized and directed investment trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. These materials are furnished for the use p of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. The information Persons contained reading in these materials materails should was consult o with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies The discussed information or c recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials Neither was the obtained information from in sources these Use materials deemed reliable. of these nor materials any Such opinion information is dependent expressed is upon herein not guaranteed the judgment constitutes as to and an its analysis offer accuracy, to applied buy timeliness or sell, by duly nor or authorized a completeness recommendation by PNC. investment to buy The information contained in these materials and opinions expressed herein are subject to change without notice. Past performance is no guarantee p o Accounts managed by PNC and its of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. PNC Accounts does not managed provide by legal, PNC tax and or its accounting affiliates advice. may take S positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice The information unless, with contained respect to in tax these advice, materails PNC Bank was has o entered into a written tax services agreement. PNC does not Securities provide services involve investment any jurisdiction risks, in including which it is possible not authorized loss of to principal. conduct The business. information PNC does not provide investment advice to PNC Retirement c Hawthorn Solutions and PNC Vested do Interest not provide plan sponsors legal or accounting or participants. advice PNC and Bank neither is not registered provides tax as a a municipal " advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services Neither provided the to information a municipal in entity these materials or obligated nor any person opinion regarding expressed proceeds herein of constitutes municipal an securities offer to buy (as such or sell, terms nor are a recommendation defined in the Act) to buy will o be provided by PNC Capital Advisors. Securities Accounts are not managed bank deposits, by PNC nor and are its they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations PNC does of not the provide FDIC, the legal, Federal tax or Reserve accounting Board, advice. or any S government agency. Securities involve investment risks, including possible loss of principal. Securities involve investment risks, including possible loss of principal. Vested Interest is a registered trademark and PNC Institutional Asset Management, PNC Retirement Solutions, and PNC Institutional Advisory Solutions are service marks of The PNC Financial Services Group, Inc. " 2013 The PNC Financial Services Group, Inc. All rights reserved.