The investment process and portfolio construction go hand-in-hand as the test of a manager’s investment philosophy. The process shows us how managers incorporate their philosophy into their portfolio decisions. Portfolio construction is the final exhibit of their investment philosophy. Retirement plan investments are intended to work for participants over the long-term, so as we’ve stated earlier in this series we believe the consistency of investment philosophy and management are key to manager selection. We want funds that will continue to fulfill the same role in investment menus today, tomorrow, and five years from now.
There are several aspects of portfolio construction that we look at to gauge a manager’s execution of their investment philosophy. One part of this review is an evaluation of the manager’s holdings range, percentage of the portfolio invested in the top 10 holdings, and annual turnover. We compare these elements to the investment manager’s stated philosophy and process. If the manager self-identifies as a high-conviction manager with a high degree of confidence in every holding, we would expect a relatively small number of holdings with a large percentage in the fund’s top ten. A manager that seeks to diversify individual company risks would be expected to have a smaller percentage of assets in their top ten. The annual turnover is evidence of a manager’s adherence to their investment process. If the fund’s manager uses a 12- to 18-month investment horizon for their company analysis and projections, we would anticipate a higher annual turnover rate, likely at or above 50%. A manager that states a 3- to 5-year investment horizon is expected to hold companies for the long-term and their annual turnover number should reflect that.
Another piece of the puzzle is the portfolio’s stated benchmark; does the benchmark fit their investment style? If they’re an international manager with some emerging markets exposure, we’d expect them to use a benchmark that has some emerging market component. If they’re a value fund, we’d expect them to use a value-oriented benchmark. Why is this important? Managers frequently set limits on their portfolio’s investable universe and exposures to match their benchmark index. While many managers place few hard restrictions on their investable universe, a number of managers limit their investable universe to match the characteristics of their benchmark (usually market cap and degree of exposure to international companies) while other managers restrict their universe to the constituents of the index.
The prospectus benchmark can also influence portfolio constraints on international exposure as well as sector, industry, and security weights. These constraints also serve as valuable evidence of a fund’s degree of adherence to its investment mandate. Some portfolio managers use an absolute approach, such as a cap of 25% on investment in any one sector. Other managers use a relative approach and assign an acceptable range of investment based on the index weight; continuing with our sector example, a fund may limit its exposure to +/- 2% of the benchmark weight. These constraints also serve to inform performance expectations. As of October 31, financial stocks made up more than a quarter of the weight of the Russell 1000® Index. Much of a large cap value manager’s benchmark-relative performance over the last few years can be explained by their financials weight relative to the benchmark. The size of the relative range therefore also becomes an important element of the fund’s risk controls.
Investors should be compensated with performance commensurate to the fund’s degree of risk. That said, most plan sponsors don’t want plan investments to assume more than a moderate amount of risk. Portfolio managers have many tools to mitigate risk such as the strength of their research process or quantitative models; absolute or benchmark-relative constraints on investment based on geography, sector, industry, and individual security levels; and factor exposures (such as quality and momentum). In our review process, we look at the manager’s risk procedures: how frequently they review portfolio risks, what reports they review, and how they are held accountable for their portfolio’s risk, performance, and adherence to investment philosophy.
Some smaller firms keep risk management limited to the team level and use a quantitative reporting group to generate regular risk exposure and performance attribution reports. Most managers use these reports to look for unintended risks rather than as hard warnings. Many larger investment management firms take risk awareness and management a step further and include regular risk reviews (typically semi-annual or annual) by the chief investment officer (CIO), senior investment staff, chief risk officer (CRO), and/or fund boards. In these cases, we typically look at the degrees of separation between portfolio managers and risk oversight, with a preference for strong risk reviews and risk departments that report directly to the CIO or CRO.
A fund’s stated investment process, construction, and risk management give our team necessary insight into an investment manager’s ability to execute on their stated philosophy and mandate. These elements provide evidence of an investment manager’s consistency and thus their long-term ability to maintain a specified role in the plan sponsor’s investment menu and provide participants with a necessary tool for building a diversified retirement portfolio.
To read our previous posts in this series, see below.
Episode 1: Introduction
Episode 2: Philosophy & Process
Episode 3: Team Structure
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.