Manager Hunt

Search Triggers
The events that most commonly lead to a manager search include organizational issues, asset mix reallocation and failure to meet performance objectives.

Organizational issues that should raise a red flag for pension plans include a merger, a regulatory investigation, a significant change in assets under management, firm-wide layoffs and the departure of key investment personnel. When an incumbent manager announces extensive layoffs, the plan sponsor should consider the manager’s ability to retain and attract new business and its ability to support the investment function. When key members of the investment team depart, the plan sponsor must assess the manager’s ability to sustain the investment style, process and performance record of the departed personnel. A large gain in assets or accounts is an issue, since this may challenge the manager’s capacity to execute the mandate or to provide client service.

Another type of event that may lead to a manager search is asset mix reallocation. Triggers are outlined in Figure 1.

However, the most common reason for a manager search is failure to meet investment objectives. Performance objectives are specified in a plan’s Statement of Investment Policies and Procedures (SIP&P).
The SIP&P will state that the manager is expected to exceed a certain benchmark by a predetermined amount. Often, the manager will also be expected to perform above the median of a peer group of managers with similar mandates. The time frame will extend over several years, and multiple end points may be considered.

This list of events that can lead to a manager search is not exhaustive. Other potential triggers could include a violation of the guidelines established in the SIP&P or in the manager’s mandate and a change in the manager’s investment philosophy or approach.

While none of these events would trigger an immediate manager search, they would lead to a predefined sequence of steps that precede a termination decision. First, the manager is alerted to the specific deficiencies and informed that it has been placed “on watch.” If the manager fails to remedy the deficiency after a defined period, the plan sponsor undertakes a series of reviews that escalate in scope.

In the case of underperformance, the plan sponsor may review the manager’s mandate, the appropriateness of the benchmark used, the manager’s compatibility with the fund’s objectives, evidence of style drift and the sources of value added or subtracted. A higher level of review would involve a complete reassessment of the manager’s organization, personnel and investment decision-making process. Once all reviews are complete, the sponsor will be well positioned to decide on the retention or replacement of the manager.

Involved Parties
Good governance dictates that the parties responsible for policy establishment should be separate from those responsible for policy implementation. For example, the board, as the highest level of oversight, should ensure that the stated policy asset mix reflects the fund’s objectives and desired risk level. Time spent discussing individual investments or specific managers will crowd out the essential policy discussions.

Boards should delegate the implementation of their policy decisions to a standing committee, such as a pension committee, or to senior investment staff. The implementation function includes manager searches and the hiring/firing of managers.

Do consultants add value to the manager search process? This has been the subject of lively debate in the CFA community, according to recent issues of CFA Magazine. Proponents say that consultants offer expert knowledge of investments and managers, an independent view, a resource to supplement constrained internal resources and an established, efficient search process. Opponents say consultants suffer from shortcomings such as a bias against passive strategies, a focus on short-term versus long-term performance, a reliance on publicly available data and a lack of clear recommendations.

In this debate, there are two additional considerations. First, the job of the investment consultant is to support the pension plan’s fiduciary responsibility—a duty that means ensuring that investment decisions, including manager selection, are based on a systematic and informed process. It does not mean guaranteeing manager outperformance.

Second, a pension plan should assess an investment consultant’s conflicts of interest in the context of materiality and the fullness of disclosure. The U.S. Securities and Exchange Commission and the Department of Labor have developed a set of questions, “Selecting and Monitoring Pension Consultants: Tips for Plan Fiduciaries,” to help plan sponsors evaluate the independence of pension consultants. For example:

• Do you or a related company receive any payments from money managers that you recommend, consider for recommendation or otherwise mention to the plan sponsor for consideration? If so, what is the extent of these payments in relation to your other revenue?
• Do you have any policies or procedures in place to address conflicts of interest, or to prevent these payments or relationships from being considered when you provide advice to clients?

Main Steps
When the plan sponsor decides to undertake a manager search, here are the key steps in the process.

1) Screen the universe – The search begins with a determination of the essential attributes of the desired manager, which are used to screen a large universe of relevant managers and distill a list of six to eight candidates. Attributes may include:

• an established investment team with low turnover;
• a minimum level of assets under management (overall or in a specific asset class);
• no significant negative issues involving the overall organization;
• above-median performance over the past five years;
• below-median performance volatility over the past five years; and
• reasonable fees.

The screening process is a compromise between the number and strictness of the screening criteria, and the number of the resulting candidates. This step is critical. If the initial screening is performed mechanically or is omitted, it will undermine the search process.

2) Conduct due diligence – Once the plan sponsor has established a list of candidates, it will need to collect data on each organization, the investment product of interest, key investment personnel, performance and fees. Data can be collected through a variety of databases or through requests for proposals (RFPs) issued to each manager.

For RFPs, the CFA Institute provides a template, “Model Request for Proposal,” for each of three asset classes: equity, fixed income and real estate. For example, to capture information on a manager’s organization, the template RFP solicits information on firm history, organizational hierarchy, regulatory oversight body, insurance policies, firm personnel, client service and reporting, compliance, voting practices, internal controls, risk management practices, potential conflicts of interest, and trading practices. The information is then validated and analyzed.

Given the wealth of information collected, the challenge is to decide which factors are important and which factors truly differentiate the candidates. A 2004 study by Jerry Parwada and Robert Faff, Pension Plan Investment Management: An Empirical Analysis of Manager Selection, may prove instructive. They studied selection factors in a sample of 242 domestic equity mandates in the Australian market from 1998 to 2002. In general, they found that performance factors were statistically significant in manager selection—whereas risk factors, unfortunately, were not.

After determining the important factors, it is necessary to establish their relative weight. For example, should cost be 20% or 30% of the overall evaluation scheme? The importance of the selection factors will reflect the different priorities of different pension plans.

Completion of the analysis results in a detailed due diligence report presenting all findings and the finalist candidates recommended for interviews. It’s common to prepare a set of questions for the finalists in advance of the interviews, which will help the plan sponsor to focus on its priority issues. The interview will be unsuccessful if the manager is allowed to dominate with a routine marketing presentation.

3) Document and transition – Once the successful candidate has been chosen, the search process proceeds to the transition phase. The transition includes the completion of documentation, liquidation and reinvestment of investment holdings or in-kind transfers and communication to plan members. In terms of documentation, an agreement between the manager and the plan sponsor is reviewed and executed, the sponsor articulates the manager’s job description in a manager mandate statement, and the pension plan’s SIP&P is updated to reflect the new mandate.

Common Pitfalls
Here are a few of the hazards that can waylay a manager search.

Overreliance on the performance factor – Many manager searches overemphasize this aspect. In a 2003 study, The Selection and Termination of Investment Managers by Plan Sponsors, Amit Goyal and Sunil Wahal analyzed the manager hiring and firing decisions of 3,700 plan sponsors over a 10-year period in the U.S. They examined 9,581 hiring decisions, 902 firing decisions and 655 “round-trip” firing and hiring decisions. The measurement period was three years before and after the hire or fire decision. Their findings, outlined in Figure 2, underline the dangers of overreliance on performance.