Let's recap, so far we've covered our three guiding priciples to investment menu design, what we look for within an investment team's structure, and what we look for in a manager's philosophy and process. In Part 4 of this series focused on investment manager selection for actively managed funds, we will cover our last topic, portfolio construction and risk management.
Portfolio Construction and Risk Management
The investment process and portfolio construction go hand-in-hand as the test of a manager’s investment philosophy. Portfolio construction is the outcome of the investment process and provides the means to judge a manager’s dedication to their stated philosophy. Retirement plan investments are intended to work for participants over the long-term so as we’ve stated earlier, we believe consistency of investment philosophy, process, and management are key to manager selection. The building blocks of a diversified portfolio shouldn’t change shape with every change to the market; participants should have access to investments that will fill the same role in their portfolio today, tomorrow, and five years from now. That said, a manager should be open to an evolving market and continuously challenge their conviction in their guiding process.
There are several aspects of portfolio construction that we look at to gauge the manager’s ability to execute on their investment philosophy. As part of this review we look at the fund’s holdings range, the percentage of the portfolio invested in the top ten holdings, and annual turnover and 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 securities with a large percentage in the fund’s top ten holdings. A manager that seeks to mitigate individual security risk is expected to have a smaller percentage of assets in their top ten holdings. 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 above 50%. A manager that states a three- to five-year investment horizon is expected to hold companies for the long term and their annual turnover number should reflect a lower rate.
Another piece of the puzzle is the portfolio’s stated benchmark: does the benchmark fit their investment style? If they are 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? While many managers place few hard restrictions on their investable universe, some managers limit their investable universe to match the characteristics of their benchmark (by market cap, exposure to international companies, etc.). Other managers may restrict their investable universe to just the constituents of the benchmark.
The prospectus benchmark can also influence portfolio constraints on international exposure as well as sector, industry, and security weights. These constraints serve as valuable evidence of a manager’s discipline relative to their 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.
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, given the propensity of some participants to ‘chase’ returns. Portfolio managers have many tools to mitigate portfolio risk, such as the strength of their research process or quantitative models; absolute or benchmark-relative constraints on investments 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 that may have built up in the portfolio. 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 board. 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.
After selecting the investment menu categories to be offered to your participants, identifying the right managers to fill out your investment menu is the next critical step requiring careful consideration. At the heart of the selection process is our qualitative assessment of the investment management team & organization, philosophy & process, and portfolio construction & risk oversight; this detailed assessment helps to ensure that we successfully identify attractive long-term investment options. We look to quantitative information to confirm that the fund’s metrics are consistent with their investment philosophy and process. We seek to ascertain that performance, whether good or bad, can be explained by the fund’s philosophy and process. Fund expenses must be reasonable relative to their resources, scale, and peers. Putting these pieces together is key to identifying investment managers appropriate for retirement plan investment menus.
If you're interested in reading our guide focused on this topic written by our senior investment analyst, Tina Beltrone, and our investment analyst, Caryn Sanchez, please click here.
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.