A day in the life of a research house

When they use outside management, fund companies have ways of ensuring the managers with whom they trust investors’ money know what they’re doing.

We spoke to Kathleen Wylie, head of Canadian Equity Research for Russell Investments Canada, and Greg Nott, CIO, Russell Investments Canada, about their research process.

Q: How do you evaluate and research money managers?

KW: We don’t screen on past performance because it’s not indicative of a fund manager’s future performance. Ideally, you want to find a manager with a great process and unique insight when they’re underperforming.

Of the 155 products we follow, only 15 currently comprise our buy list. My compensation as an analyst is tied to that list’s performance, so I’m not going to put a manager on it unless I’m confident he or she will add value.

Q: Which red flags do you watch for?

KW: Organizational instability and high turnover.

GN: We could also see from our tools and data if a manager suddenly takes a large sector bet, when historically they’ve been small. This could indicate a process change we need to investigate.

KW: There are also times when everything looks great, but then you meet with managers and realize they don’t have much insight. We may ask for stock-specific stories, and they’re just telling us what we can read in the newspaper.

Take gold stocks. When we ask why certain managers have never owned them, they sometimes reply that such stocks are too expensive, or that they don’t understand them. It’s clear from those answers these managers haven’t researched the companies. Managers should talk not only to company management, but also to competitors, suppliers and even customers.

GN: We want managers who can demonstrate insight into why their portfolios look the way they do, or why the portfolio has changed. If they can demonstrate unique insight, that gets us excited. For instance, a fixed-income manager quickly changed its portfolio from short to long duration within one quarter. This was based on our research, discussions with central bank contacts, and previous recessions.

The manager said the 2008 crisis was going to cause a strong central bank reaction and an economic slowdown. Yet at the time, many believed the U.S. housing slowdown and the high leverage in financial institutions were manageable. That did not turn out to be the case; the manager had made the right call.

Q: What makes an investment process successful?

GN: We don’t have a specific checklist. But to create a successful process, it takes talented people with clear philosophies, consistent investment approaches, organizational continuity, the ability to implement decisions efficiently and unique investment insights.

Q: What do you consider when assessing a manager’s research process?

KW: We prefer managers do their own research using a team of in-house analysts. Managers who rely on sell-side research don’t have competitive advantages since the information is common knowledge, even if the quality is high.

Part of our due diligence is to meet with analysts and understand their level of knowledge and how they interact with the portfolio manager. We like it when analysts walk us through their models and go into details about the companies they research. We like to hear what they’ve learnt from their discussions with management.

Smaller-cap managers need to have good relationships with the company so they can get accurate and honest information. Meeting with company management is definitely one key criterion.

Q: Have you ever fired managers?

GN: Yes. Globally across Russell, there’s an average of 10% manager turnover per year. Most of the changes would be driven by downgrades from research analysts. Most people think a downgrade is performance-related, but underperformance is rarely the reason we change managers.

More often, it’s because of other factors: for example, Kathleen may downgrade managers due to organizational issues: a process has changed suddenly and the manager couldn’t explain why. Or, someone had a unique insight, and now everyone else has caught up and he’s not leading edge anymore. We could also be looking to change the portfolio structure.

Q: What’s been most challenging in evaluating managers?

KW: When there’s a process change. For instance, we may observe managers that have been moving up size exposure to larger-cap names. In that case, we would need to understand why. Was it because their assets under management have grown and they can no longer invest in smaller-cap companies? Or was it because they struggled with their performance in smaller-cap names, and are no longer comfortable in investing in that space? Or are small-cap stocks not as attractive as larger names recently? We need to assess whether or not the change is permanent.