Managing manager risk

The recent controversy over mutual fund fees has put the cost of advice under the microscope, while the cost of investment management itself has been taken as a given. These costs are higher for multi-manager solutions for one simple reason: appropriate investment selection is an ongoing process, not a one-time event.

Costs aside, clients will too often want to chase returns, using performance as the primary metric in making investment decisions. Yet Bernie Madoff’s well-publicized hedge fund fraud provides a grotesque example of how flawed such a decision can be; for years it was a paragon of consistent returns.

In light of blow ups like Madoff and Canada’s own problems in the asset-backed commercial paper market, advisors have an even more onerous fiduciary obligation to ensure that they select the appropriate investment mandates for clients.

Regulators, the financial press and investor advocates have all been vocal in demanding advisors and their dealers be more rigorous in the process they use for investment selection.

Investors may not realize the degree of portfolio management that multi-manager programs provide, including substantial due diligence processes that would be difficult for investors to duplicate on their own. Active portfolio construction is a complex process that takes considerable time and expertise, which providers argue requires compensation above and beyond a “couch potato” portfolio of exchange-traded funds.

“With fund failures such as Madoff, I think you see these certain cycles where an emphasis on due diligence becomes more important. Trying to assess manager level risk is important. There is a tendency to want to diminish it as being insignificant at times, but it is not,” says Roy Borzellino, senior portfolio manager, SEI Canada. “What you have to do is make sure there are enough controls in place so that risk is mitigated at best, or at worst, it is contained.”

Doing this requires much more work than simply having an investment outlook and finding managers with consistent historical performances who fit within that outlook.

Transparency is important

SEI undertakes months of rigorous quantitative and qualitative evaluation before it adds a manager to one of its multi-manager funds. Once a manager has been selected, the firm insists on complete transparency and daily reporting so it can quickly flag any changes in the manager’s fund that could be problematic.

For example, style drift is oft-overlooked manager behaviour. Past performance is not a great indicator of future success, but investors generally place money with a manager under the assumption it will employ a consistent investment style. It’s crucial that managers stay true to form, since a mandate has been carefully selected to have correlations and return expectations that should differ from other holdings in a client’s portfolio.

“Every time you hire a manager, you’re implicitly hiring them for certain skill — a skill that’s observed in the past,” Borzellino says. “If a manager departs from using strategies that may not have the same consistency, or the same success ratio, that exposes you to more risk [within the portfolio]. That new investment philosophy creeping into the portfolio can take away from what they’ve been good at and where [the manager] has built its reputation.”

Meet the managers

Borzellino says the same consistency needs to be observed with the people that an investment firm employs. He says he puts a lot of stock into how an investment firm conducts its day-to-day business operations apart from money management, as well the personal relationships it builds with individual managers.

“Because we are a large, sophisticated buyer, we have tremendous access. I can phone up any one of our PMs and they’ll take my calls and answer my questions,” he says. “I can have real-time discussions in terms of positions being put in a portfolio. We can ask what their view is on a particular name being put into the portfolio. If we start to see one name is starting to dominate the active risk, we will ask how much confidence they have in that name.”

Managing the manager relationship was one of the reasons AGF selected Wilshire Associates to oversee the Harmony program — its portfolio product line, says Rob Badun, executive vice-president, investments with AGF Management.

“Wilshire has direct access to portfolio managers and to qualitative information that gives them insights that performance history alone cannot provide,” he says. “No new mandates are added without having at least one in-depth, face-to-face meeting with portfolio managers. Furthermore, these meetings would only occur after rigorous analysis and quantitative research within Wilshire’s proprietary database of more than 6,000 investment strategies and its universe of managers.”

Borzellino says his company ties their partnership with a firm to the retention of specified money managers.

“If there is a change in the management of our account, we have to be notified within 24 hours by the firm,” Borzellino says.

He feels that too often, advisors accept the business-as-usual argument put out by investment firms when a star manager leaves a mandate.

“That’s deer-in-a headlight behaviour in our view,” Borzellino explains. “You hired an individual to manage your money, and if that individual isn’t there any more then you have to make a decision whether you still want that firm managing your money.”

(05/20/09)