Avoiding the Pitfalls: Best Practices in Manager Research and Due Diligence

Avoiding the Pitfalls: Best Practices in Manager Research and Due Diligence Brian Tipple Chief Investment Officer, Equities Russell Investments London R Disappointment with investment manager selection can be reduced by considering the tangible 4 P s (people, process/philosophy, portfolios, and performance) and the intangible 4 P s (passion, perspective, purpose, and progress). In addition, strategic-partner risk can be better understood with a thorough due diligence program that identifies operational, trading, and regulatory risks. ussell Investments has spent more than 40 years seeking to identify what differentiates skillful managers and their future fund outperformance from other active management participants. The purpose of this presentation is to describe our manager research process and, in particular, the way in which we evaluate the assumed strategicpartner risks when we hire a money management firm for our funds business. This presentation comes from the 2009 CFA Institute European Investment Conference held in Frankfurt on 21 23 October 2009. Evolution of Manager Research Process In 1969, Russell Investments hired its first research analyst in charge of evaluating managers. During the next 5 10 years, we expanded our manager research capabilities and began to develop a systematic process for evaluating money management firms. In doing so, we developed what we now refer to as the Old 4 P s to help guide the conduct of our manager research meetings. As our thinking evolved, we came to recognize that although our approach was systematic, it did not necessarily identify all of the key success factors that we had observed at successful money management firms over time. As a result, we developed the New 4 P s, which are intended to complement our traditional approach as well as to identify those characteristics we believe improve the prospects for better investment outcomes in the future. By 2000, we began considering not only risk and return in the traditional sense but also the need to better understand and control the relationship risk inherent in the managers we hired to manage Russell funds. This evolution in thinking required that we look deeper into the business practices of money management firms and attempt to minimize the inherent strategic-partner risks. Historically, we have experienced about a 15 percent annual turnover rate among money managers in our funds. This rate means that any manager we hire will likely represent a long-term relationship that must be evaluated at a strategic level. In partnerships such as these, both parties should recognize their mutual obligations as well as potential business risks. For these reasons, we introduced a formal manager oversight program. Alpha Engine Focus The original focus of our manager research process was on the Old 4 P s: people, process/philosophy, portfolios, and performance. We still consider the Old 4 P s an important part of our manager research, so it is worth briefly reviewing each P. The Old 4 P s. We begin with people because investment management is a people business. It is all about strong individual investors or a team of strong investors that is expected to generate the returns that clients expect. We then focus on a management firm s investment process or philosophy because understanding how the process works and how it aligns with the people involved in the organization is critical. Next, looking inside portfolios allows us to determine whether the portfolio approach that a manager describes matches reality. Finally, we consider performance, from the perspective of understanding how past performance patterns match what we have observed from portfolio trading decisions and what we have heard from the investment manager or investment management teams. 46 JUNE 2010 2010 CFA Institute cfapubs.org

Avoiding the Pitfalls The Old 4 P s outline a framework for structuring our meetings and discussions with money management firms. But the Old 4 P s do not necessarily allow us to evaluate the intangibles that we eventually have come to believe are part of key success factors. We believe these success factors help improve our chances of identifying skillful managers in whom we have high confidence about the probabilities of their future outperformance. The New 4 P s. To better identify the essential intangibles, we developed the New 4 P s as a complement to our original manager research approach. They are passion, perspective, purpose, and progress. The New 4 P s have allowed us to categorize the characteristics of firms that we believe improve the possibilities of identifying superior managers. Passion. Passion is a powerful emotion. When we sit down with investment managers, we can observe passionate behaviors, not necessarily from the volume of their communications or from the specific words they choose but from their intensity. We are looking for highly motivated and intensely competitive managers who are focused on excellence if not perfection. As an example of passionate behavior, consider the typical day of a manager we have known for almost 20 years. At about 5:00 a.m., the alarm clock goes off. The manager rises and goes to the office next to his bedroom where, throughout the night, his specially programmed computer has been gathering information about developments in the Asian markets. He focuses on certain stock-specific issues, such as earnings reports, but because he manages a global product, he is also looking for broader geographical insight as well. After an hour or so, he has breakfast with his wife. He then arrives at his office around 8:00 a.m., where his team has been working for more than an hour and preparing to discuss any news that might be relevant to the firm s investment positions. From then until about 5:00 p.m., the manager involves himself in classic fundamental research speaking with company managements, suppliers, competitors, world leaders, and so on. At about 5:00 p.m., he typically heads to the golf course for about 90 minutes worth of practice at the driving range or putting green before heading home to enjoy dinner with his family. After dinner, he is back in his home office until he turns off the lights around midnight. He seemingly gets by comfortably on five hours of sleep, and then the day starts over again. Not every successful manager shares these behaviors, but this manager demonstrates to us that he not only loves the business; he lives the business. He has been incredibly successful. Yet every day presents a new challenge for him, and that keeps him interested and driven to excel. Although passion is largely an intangible factor, we also evaluate other factors in this category, such as employee interaction, the firm s incentive structure, and personnel turnover. Perspective. Managers with perspective know the limits of their capabilities and, generally, possess strong sell disciplines. In general, it seems that many investment management firms struggle with this critical part of a successful investment process. The key market drivers of a firm s performance results and the time horizon of those drivers are often not broadly understood. For example, an international investment manager we knew called his clients after an amazing two-year run and told them it was time for him to give back their money. His research team was unable to come up with suitable investment ideas, and as a result, he thought he was likely to underperform for a period of time. He made this recommendation more than once, and his timing tended to be quite accurate. This manager s behavior indicated to us that he had perspective. He understood not only what he could do and how his clients would benefit but also when his investment approach was likely to enter a period of softer relative performance. When evaluating perspective, we consider evidence of a strong sell discipline but we also consider how managers respond to both good and bad performance periods. We are interested in the way they construct their portfolios and how they treat mistakes. Many managers, when dealing with a stock that generates disappointing results, simply sell the stock and move on. But managers with perspective analyze why the decisions they made did not work out and try to learn from the experience. Some managers with perspective extend their core competencies into new areas, but they also have the discipline to limit the amount of money they are willing to manage because they understand the limits of their investment strategy s capabilities. Purpose. Thomas Huxley once said, Patience and tenacity of purpose are worth more than twice their weight in cleverness. We think Huxley sums up our approach to purpose fairly well. Managers with purpose are committed to their investment philosophy. These managers are incredibly protective of their competitive advantage. The manager I mentioned earlier who recommended that he give his clients money back demonstrated purpose around his investment process. He was willing to wait until he thought his approach would 2010 CFA Institute cfapubs.org JUNE 2010 47

CFA Institute Conference Proceedings Quarterly be successful again. When that manager went back to his clients to tell them it was time to invest again, he had built up so much credibility that his clients were very willing to take his advice. He had shown that through the investment cycle he maintained a disciplined and focused investment approach and held himself accountable for his decisions and performance of the portfolio. When evaluating purpose, we consider several factors. Firm structure is important. Generally, managers who have large personal stakes in their firms are often the most committed to achieving successful outcomes for clients. Idea generation is another factor of great importance. We like to understand how the firm is managing ideas from all members of the team and how these ideas are incorporated in the portfolio. We also evaluate staff training, individual workloads, and how roles and responsibilities are assigned within the team. Progress. One characteristic of managers who are willing to progress or evolve is that they tend not to be very comfortable with the status quo. One very successful manager we know is incredibly talented and has generated a remarkable track record for more than 20 years. Yet, when we visit him, it is difficult to tell from his demeanor whether his portfolio is performing well or poorly because he never seems pleased or contented. Despite his long-term success, he is never comfortable with what is happening at that moment and is always worried about what could happen next. Managers such as this one are often quite comfortable with change. They recognize that markets evolve and that they need to adapt to remain relevant and effective. But besides seeing that they are willing to change, we are also interested in how they change. We want to know how their investment process evolves over time, how they manage changes in their investment teams, and how they adapt their thinking to new information. We also evaluate how a management firm approaches its ongoing R&D efforts. It is always a bit surprising when managers call to tell us they are thinking of making a change to their investment process and would like our opinion. Our philosophy is that managers know best what is likely to be an effective change to their investment process. We expect that managers will tell us how they have incorporated their latest research into improving future investment results. To us, these are managers who understand the three critical parts of the New 4 P s but also understand how to progress in the most constructive way. Alpha Engine Focus and the New 4 P s. We believe that the New 4 P s allow us to focus more on what we have observed to be characteristics of successful firms. The Old 4 P s still provide an excellent framework for meeting and beginning the analysis of money management firms, but we are convinced that the intangibles embodied in the New 4 P s better describe the key elements of the most successful money management firms over time. The ideal firm, which is only an aspiration, has the Old 4 P s in abundance. But managers in whom we have the highest confidence will score well in the New 4 P s. Investment Manager Oversight Program Our investment manager oversight program uses specific objectives, a risk-based approach, and selection and monitoring processes to manage strategic-partner risk. Objectives of the Program. The first objective is to improve our manager decision-making ability. As a proper fiduciary, we at Russell Investments must possess a detailed understanding of the risks inherent in the decisions we make on behalf of clients. Therefore, understanding our strategicpartner risks helps us do a better job of fulfilling our fiduciary obligations. Furthermore, by communicating with managers on a frequent basis and sharing with them our global perspective on best practices about compliance, trading, operations, and business structure, we help to improve our money managers understanding of best practices. Most importantly, though, we strive to protect our clients interests. Those of us who invest based on anticipated outcomes on a daily basis do not enjoy negative surprises. This program is intended to reduce the opportunities for such surprises, even if it cannot eliminate them entirely. Risk-Based Approach. Through our riskbased approach, we target compliance, operations and trading, and organizational structure (including technology) so that we can better understand the capabilities of our investment management partners in these three areas. We are also interested in a manager s perspective about these risks. For example, compliance practices are very important to us, and our approach is designed to quickly determine whether a prospective manager also thinks it is important. Similarly, we want to understand the level of importance money managers place on the control structures within their 48 JUNE 2010 2010 CFA Institute cfapubs.org

Avoiding the Pitfalls investment firm and whether those control structures are appropriate for the firm s size, point in the life cycle, and sophistication of its product spectrum. We conduct two types of review. The first review considers policies and procedures from a global best practices perspective. It also includes a review of the firm s regulatory requirements. The second review is narrower and focuses on such things as how the firm manages conflicts of interest, its code of ethics, governance, vendor oversight, and trade processes, as well as policies on best execution and use of soft commissions. Our program is very similar to a Statement on Auditing Standards (SAS) 70 Type 1 review. Once we engage with an investment management firm and have a contractual relationship, we use more of a typical SAS 70 Type 2 review. Selection and Monitoring Process. As part of our manager research process, we rank each manager we visit based on our confidence in his or her ability to generate positive excess returns in the future as well as the stability of the firm s contributors or drivers of that expected outperformance. When a Russell portfolio manager identifies a management firm whose investment characteristics are desirable in his or her fund, the manager oversight team builds an initial questionnaire and sends it out to the firm under consideration. It also conducts further research to prepare for an on-site visit, which we consider a critical aspect of the program. Following an on-site visit, the manager oversight team reviews its findings with the Russell portfolio manager. We also share our assessment with the respective money management firms. The oversight team then assigns the manager a risk rating of low, medium, or high, and the portfolio manager presents a new manager recommendation to our investment strategy committee. The committee evaluates the prospective management firm from both an investment perspective as well as a strategic-partner risk perspective. Once we reach a contractual agreement with the investment firm, we engage in ongoing monitoring. We send quarterly and annual questionnaires, and we conduct on-site reviews on a one- to four-year cycle, depending on the risk rating we have assigned to the manager. Finally, we have midpoint conversations with the firm to assess material changes and examine how the firm has progressed around the areas of risk that we have identified. Areas of Concern. The critical reason for our manager oversight program is to protect our clients. Fraud is currently among the greatest areas of concern. Although no program can prevent fraud entirely, we believe our approach reduces the chance that we will engage with a fraudulent manager. The qualitative aspect of our review is critical because an effective oversight program is much more than just a numbers exercise. We believe that face-to-face meetings are critical because we devote time to the people who are responsible for these important processes and practices, what roles they perform, and how their experience and competence might affect our clients and us. Among the potential red flags revealed by our program, one of the most glaring is the lack of an independent, third-party audit. The lack of independent audits has often been a critical flaw that helped many of the so-called Ponzi-schemers perpetuate their crimes. The quality of the third-party audit and the reputation of the auditor is also an important consideration. Conflicts of interest also create a significant opportunity for potential problems. For example, an affiliated trading relationship between an asset management firm and its brokerage parent is a potential area of concern. Before we can be comfortable with such a relationship, we want to understand how that relationship works and how decisions are made around those trades. At a minimum, it is important that best execution testing procedures are in place and regularly monitored by senior management. Similarly, the existence of personal relationships between the investment firm and its vendors can be a cause for concern. Most firms have gifting policies that are reviewed by compliance teams every quarter. We are trying to make sure that the relationships between vendors and investment personnel are appropriate. We look carefully at personal trading procedures to ensure that a clear policy, consistent with best practices, is in place. Finally, a firm s governance and management structures are critical. We want to understand the firm s reporting relationships, its structured flow of information, and its separation of duties. Case Studies The following scenarios are based on a few actual incidents that were revealed through our investment manager oversight program and should highlight the value such a program can offer. Protecting Reputations. During an on-site review with a U.S. equity manager, an impending regulatory action by the U.S. SEC was disclosed. Our manager oversight team immediately shared this information with our manager research and portfolio management teams, who then contacted the management firm directly to develop a better understanding of the nature of the violation. We then assessed the impact of the SEC action on the 2010 CFA Institute cfapubs.org JUNE 2010 49

CFA Institute Conference Proceedings Quarterly manager s business and investment process and ultimately decided to retain the firm. We immediately apprised our clients and representative boards of the situation and the rationale of our decision. Being on-site helped us uncover a situation that could have been embarrassing for our clients and us. It also allowed us to understand the risks identified by the SEC and put that risk in the context of making a good investment decision. Improving Manager Practices. The following two examples show how our process can help our managers improve their business practices. Case #1. During a prehire visit with an emerging growth manager, we found a material conflict of interest in the firm. One person was responsible for operations, trading, and compliance. Accordingly, we helped this firm identify ways to separate its compliance function from its operations and trading. Ultimately, the firm retained a thirdparty vendor to do its external compliance. Case #2. During an on-site review of an emerging markets manager, we found that several of its processes were not consistent with what we believed to be best practices. We had, however, very high confidence in the manager s investment capabilities. The team was very small, and it lacked controls expertise. This firm was particularly lacking in the area of regulatory compliance, an area of particular focus for us. In this case, we shared our recommendations with the manager and actively helped it develop a suitable set of policies and procedures. Avoiding Fraud Is It Really Possible? As with many other firms, our focus has long been on excess return generation for clients and the risks associated with the investment process. But the numbers of recent Ponzi-like scandals have dramatically revealed the layer of risk associated with hiring an investment manager. Although it is impossible to completely avoid fraudulent situations in the future, we believe steps can be taken that help maximize the probabilities of avoiding such negative events. The biggest Ponzi-like scheme to date that occurred recently affected a large number of investors for a staggering amount of money. Each of us has now heard of Bernie Madoff s crime and the significant black eye his situation has given the investment industry. As such, it has become increasingly important to adopt oversight programs to help avoid such disastrous events in the future. There are a number of important lessons we have learned from reading about how Madoff is said to have run his business. First, Madoff reportedly did not engage in thirdparty audits, which should have raised a red flag because, as was mentioned earlier, we believe that third-party audits are critical to ensure that proper checks and balances are in place. Furthermore, Madoff reportedly had no independent custodian. When a client s account was opened, it was set up as a brokerage account that apparently went straight to Madoff s own computer. As with third-party audits, independent custodians are a fundamental part of safekeeping client assets. Finally, Madoff reportedly did not welcome on-sight client visits at his office in Manhattan. We believe on-sight, face-to-face visits are a critical requirement of an effective manager oversight program because it helps to understand what control programs are in place, the qualifications for those who manage these programs, and a firm s attitude about these types of risks. Conclusion Russell Investments definition of manager research and proper manager due diligence has evolved and will continue to evolve. Our focus not only remains on identifying future successful investment managers but also emphasizes the importance of proper manager due diligence. This focus is driven by the desire to understand all potential risks business risk as well as investment risk. We believe the best practice for hiring investment firms places great focus on these two important areas. This article qualifies for 0.5 CE credits. 50 JUNE 2010 2010 CFA Institute cfapubs.org

Q&A: Tipple Question and Answer Session Brian Tipple Question: When you visit a manager on-site, do you prefer to meet portfolio managers, the executive management, or both? Tipple: Both. When our manager research team visits, our primary focus is on meeting the key investment decision makers as well as understanding the investment process. Ideally, we like to meet with all the members of the team, such as research analysts. Often the executive teams can help us understand how the firm structures incentive programs, manages personnel changes, and so on. These are important factors in understanding where a firm fits within the context of the Old and New 4 P s. When the oversight review team visits a firm, the compliance and operations members of the manager s team have an opportunity to shine. We have been told that this focus on business practices often gives the firm s compliance, operations, and trading teams a greater level of importance within the manager s organization, even if only on a temporary basis! Question: Do you find the New 4 P s in firms of all sizes, or do small firms have an advantage? Tipple: Size is not critical; people are. We see great people with incredible skills who are part of both large and small organizations. Question: Can passion be dangerous? Can it lead to excessive risk taking and a weak sell discipline? Tipple: Yes. Those factors are why we do not look only at passion. Passion to us means a love for going to work every day and for achieving excellence, but it needs to be balanced by other aspects of success. Overly passionate people may think they can never be wrong. Yet, we all know that being wrong on occasion is part of the investment business. Question: Do you put more emphasis on the firm or on one person? Would you follow the person to a new firm? Tipple: Because we believe investment management is a business in which talent lives within the person, we place more emphasis on the individual than the firm. Because we seek to identify those investors with skill, we have followed managers and shifted fund assets from one firm to another. Question: Because you have deemphasized the pursuit of alpha, how do you balance your clients need for alpha against the cost of performing a due diligence review of a new manager? Tipple: Let me be clear. Our focus is still first targeted toward identifying talented individuals, so we are not de-emphasizing alpha in our process. We do think, however, that we are complementing this alpha focus with a necessary understanding of the partnership risk as it relates to our funds business. We have a ratio of about 5 to 1 in which specialists focus on manager research versus manager due diligence. This ratio largely reflects the number of managers we research versus the number of managers who are our strategic partners. Overall, however, our manager hiring decisions are driven by the alpha proposition, and I think we do a good job balancing that against our desire to minimize strategicpartner risk. Question: How long do you take to complete your due diligence process for a new manager? Tipple: It varies. Often, when our research analysts meet with a firm, they quickly have a sense of the key excess return drivers in the manager s investment process. Sometimes, this meeting is quite short and may be the last meeting with this manager for quite some time. Otherwise, a follow-up meeting may last between two and three hours. With high-interest managers, we may have another two to three hour meeting before a formal rank is given. On the due diligence side, our researchers typically spend three to four hours on-site with a firm. Although before that meeting, they will probably spend five or six hours reviewing responses to our questionnaire and preparing for the manager visit. There are also usually follow-up telephone conversations to clear up outstanding issues. Question: Do you believe that the current incentive structure works well for the industry? Tipple: I guess it depends on how one defines the current incentive structure. Overall, though, aligning incentives with client outcomes is what we try to do and what we think is best practice. 2010 CFA Institute cfapubs.org JUNE 2010 51