Jun 26, 2018
Newport Group believes that investment managers should be selected and monitored using a well-defined process. Our dedicated team of research analysts combines both quantitative analysis and qualitative research in order to help identify investment managers we believe could potentially provide superior long-term performance. The process also incorporates a comprehensive and continuous review of all recommended manager.
Quantitative screens are used as a starting point in the manager due diligence process to focus our research efforts on the most promising managers within a given asset class or investment style. We do not believe, however, that past performance should be the most relevant factor in the investment manager selection process. Research studies have found little evidence to support this theory. Reasons include the following:
- top performing managers tend to experience significant asset growth, which may lead to declining flexibility, notably for managers who invest in less liquid securities
- asset growth may result in increased team size, which could potentially reduce the responsibility of the key members who originally established the track record
- investment success often leads to increased responsibilities for the investment professionals, including additional mandates to manage and increased public appearances
- successful managers are more likely to be recruited by a hedge fund or other asset management firm
- effective techniques may be copied or improved upon by other asset managers, which removes the competitive advantage
- successful managers may become overconfident, which may increase the likelihood of becoming complacent, taking shortcuts or making other hasty decisions
While past performance is not a reliable indicator of future results, it is a useful tool in screening for managers that may be worthy of further research. Our analysis is focused on discerning why the manager performed well, and whether we believe the portfolio management team has an identifiable advantage that can be maintained going forward.
Newport Group classifies managers using both returns-based and holdings-based style analysis. A rules-based methodology is used to assign each manager to the most representative asset class based on returns-based analytics, as well as holdingsbased analytics from various data providers. The classifications may be subjectively overridden by an analyst when further analysis deems that a manager was misclassified using a purely rules-based method.
Newport Group utilizes a proprietary manager evaluation model to narrow the investment universe to a more manageable level. The model ranks managers in each asset class based on several variables, including return, risk and consistency. We place a strong emphasis on managers that generate superior risk-adjusted returns versus their respective peer groups and best-fit benchmarks. We examine managers based on several factors to verify excess performance was attributable to manager skill and within a reasonable range for diversified investment managers. The key screening criteria include:
- style consistency
- correlation to the benchmark
- risk-adjusted return
- performance consistency
- excess return
- downside risk
- expense ratio
Correlation - A measure of an investment's movement in relation to another.
Risk-Adjusted Return - The annualized return of the investment minus the annualized return of three-month U.S. Treasury bills, divided by the annualized standard deviation of the investment's returns.
Downside Rise - The potential loss that may occur as a result of a market decline.
We place greater emphasis on long-term results in order to better distinguish investment skill from luck. Investment managers who rank in the top third of our evaluation model over the trailing five- or seven-year periods are candidates for qualitative assessment. We may consider an investment vehicle with a short track record (less than three years) if the manager has an institutional track record representative of the underlying investment strategy. We also favor investment vehicles with relatively low expense ratios, as the long-term compounding effect of higher expenses can be severely damaging to investor returns.
We believe that qualitative research is the most critical step of the manager selection process. This step further refines managers from the quantitative screen by focusing on attributes that are more likely to persist over time. The most appealing managers in our evaluation model are candidates for qualitative analysis by Newport Group’s research analysts. Our research efforts are primarily focused on the firm’s organizational history, structure and stability;the depth and experience of the investment team and research group; the investment process and strategy; internal resource allocation; legitimacy of the track record and client servicing capabilities; among other characteristics.
Step 1 – Initial Review of Manager Evaluation Model Results
After reviewing the initial manager evaluation model results, the universe is further reduced by the research analyst based on an initial qualitative assessment.Strategies that screen well, but that have experienced material management turnover or investment strategy changes, are eliminated from consideration. In addition, the investment vehicle must meet a minimum asset threshold. Vehicles with less than $100 million in assets will not be recommended due to viability concerns. Finally, mandates that fail to provide dedicated asset class exposure or offer significant stock concentration risk (<35 stocks in equity portfolios) will also be removed from consideration.
Step 2 – Information Request
A Due Diligence Questionnaire is a means of obtaining more detailed information about each investment manager. Newport Group has developed manager questionnaires that cater to the specifics of each particular asset class. The questionnaires are focused on the key aspects of the firm and the investment strategy: organization, investment philosophy and process, and performance. A summary of each area is described below:
Organization – organizational history; stability of firm; ownership structure; strategic focus; core competencies; integrity; depth, stability and experience of investment professionals; investment staff turnover; retention tools; talent pool; succession planning; division of investment, and information security practices.
Investment Philosophy and Process – universe of securities; idea generation; buy/sell discipline; decision-making process; valuation methodology; portfolio construction; risk management techniques; process enhancements; resources; and trading practices.
Step 3 – Portfolio Manager Interview
After a research analyst reviews the questionnaire and analyzes historical performance, he/she will interview the investment team. During the interview, the analyst will evaluate the manager’s ability to clearly articulate the process, his/her discipline in executing the strategy, and specific examples that are in line with how the investment process was described. We also consider to what extent stocks were researched and whether buy/sell decisions have been in line with the stated investment philosophy.
Recommended managers tend to possess significant comparative advantages that may result in alpha generation going forward. These characteristics may include:
- demonstrated consistent outperformance versus benchmark and peer group across various market cycles
- seasoned professionals focused on long-term investment opportunities rather than market fads
- conviction in investment decisions and a willingness to deviate from the benchmark
- a strong commitment to proprietary, in-depth research leading to sound, long-term investment decisions
- access to information not readily available to competitors; this may be the result of strong networks and on-the-ground research capabilities
- superior skill in the interpretation of existing data to estimate the future relative returns of securities due to insightful investment professionals and proprietary decision-making models
- superior skill in the construction of portfolios and risk management that may produce favorable outcomes for clients
Alpha - The amount of return produced by a manager that is in excess of the benchmark return after adjusting for risk.
Step 4 - Manager Recommendation
Newport Group maintains a Focus List, which includes the best managers our research team has identified in each asset class. In the context of a given plan’s overall menu, where we seek complementary skill sets and diversification among investment managers, the Focus List forms the foundation of our manager recommendations. If an analyst believes that an investment manager is worthy of being added to the Focus List, he/she will present the manager to Newport Group’s Investment Committee. This includes a written institutional research report, the ranking of key quantitative factors, and other supporting materials. Each institutional research report is developed, with some flexibility based on the relevance of information for a specific strategy, to include qualitative-based observations on the following items.
- firm stability and ownership structure
- assets in strategy and capacity
- management tenure and background
- depth and breadth of resources
- decision-making authority
- investment objective and goals
- philosophy and process
- portfolio construction and risk management
- strategy opinion
- competitive advantages
- performance review
- risk profile
- performance expectations
The members of the investment committee will challenge the analyst to defend his or her recommendation. If any material issues arise, the analyst will schedule a follow-up call with the manager and report back to the committee. If the manager is approved to be added to the Focus List, the institutional research report will be updated on an on-going basis.
Step 5 – Ongoing Monitoring
The ongoing, systematic monitoring of the investments held by our consulting clients is an essential step of our manager due diligence process. The objective is to verify that the investment manager retains the attributes that served as the basis for the initial recommendation. We regularly communicate with asset management firms to ensure that our decisions about manager retention and/or replacement are made in a timely and informed manner. Newport Group holds more than 250 manager meetings annually and research notes are shared internally through our proprietary manager meeting database.
Our analysts also conduct a thorough review of each recommended manager on at least a quarterly basis. The manager monitoring process includes a performance review, as well as a review of other variables that are often directly related to performance, including manager stability, style consistency, fund expenses, investment process changes and asset manager mergers and acquisitions.The information from our regular monitoring of investment managers is communicated to clients in our Quarterly Investment Manager Review.
As part of our quarterly review, the Newport Group Watchlist process allows analysts to address issues such as manager replacements with Newport Group’s Investment Committee on a consistent basis. A manager may need to be replaced due to factors such as the departure of the key member of a portfolio management team, a change in style or investment strategy, firm uncertainty due to an event such as an acquisition, or poor relative performance with little confidence for future improvement. Some qualitative changes, such as an abrupt manager departure with no obvious successor in place, may warrant immediate action.
We consider it important for investors to be patient with managers who may be underperforming due to their style being out-of-favor. As such, managers who are on our Watchlist for failing our performance criteria are given up to two years to remedy the deficiency, providing a four-year evaluation period. This assumes that the underperformance is primarily driven by the consistent application of the manager’s established process, in a manner where the under performance would be expected. We believe that understanding performance expectations through a disciplined manager research process is integral to achieving long-term outperformance versus passive indexes.
Gina Rowland AIF®
, Senior Investment Research Analyst
Newport Group Consulting, LLC (“NGC”) is a Registered Investment Adviser and affiliate of Newport Group, Inc. All processes and analysis are the proprietary intellectual property of Newport Group Consulting, LLC.
The information contained herein is solely for educational purposes and any discussions concerning investments should not be considered a solicitation or recommendation by Newport Group, Inc. Prior to making any investment decision, an investor should independently evaluate the relevant risks involved and ensure that such investment is appropriate and suitable for the investor in light of their investment objectives, trading experience, time horizon, financial resources, risk tolerance, and other relevant circumstances. Past performance does not indicate future results. Consult with a financial, legal, and/or tax advisor.
There is no guarantee that investment managers will achieve superior long-term performance. Investment in securities involves risks, including possible loss of principal. The information contained in this paper is for informational purposes only and does not constitute legal advice. The contents of this paper are provided on an “as is” basis without warranty of any kind and Newport Group does not assume any liability for any errors, omissions or damages resulting from the use of information contained herein. This document may not be reproduced or transmitted in any form or by any means without Newport Group’s
written permission. FOR INFORMATIONAL PURPOSES ONLY.