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MUTUAL FUND DUE DILIGENCEPresented to FIRMA By R. James Hrabak, CFAMarch 28, 2012
About the Presenter
R. James “Jim” Hrabak is Chief Investment Officer for MB Financial Bank’s Asset Management & Trust Group, where he is responsible for over $3 billion in assets under administration and nearly $1.8 billion in assets under management. His team of three Portfolio Managers and five Securities Analysts specialize in asset allocation, portfolio construction, and security selection for individual and institutional clients.
Jim received a BBA., double majoring in Finance and Economics, from New Mexico State University, an MBA with a concentration in Financial Management from the University of New Mexico, and is also a Chartered Financial Analyst.
Jim is a member of the CFA Institute as well as the CFA Society of Chicago.
2
General Items to Consider (Before Designing a Due Diligence Program)
What is Our Investment Philosophy? In-House Management vs. Outside Expertise Active vs. Passive Management Mutual Funds vs. ETFs How Much Style Drift is Tolerable?
Special Note: All of the above should be greatly influenced by your firm’s investment management resources.
3
The Importance of an Investment Philosophy
Is your philosophy a known commodity?
Why is philosophy important? Due Diligence Program (and all investment functions)
should reflect your firm’s investment philosophy
Don’t have a clearly articulated philosophy? The items to consider on the previous slide can serve as a guide for creating one.
4
In-House Management vs. Outside Expertise
The 1992 restatement of the Prudent Investor Act: Allows delegation of investment management States that investments should be viewed in the context of the total portfolio Risk/return tradeoff is the central consideration
Firms are essentially required to seek out expertise in investment areas that improve the risk/return tradeoff in their client’s portfolios
Firms should carefully evaluate what they can do “in-house” versus what they should hire outside expertise to perform
Investing in a mutual fund (or an ETF ) is a form of hiring outside expertise
Firms should balance what they can competently and effectively perform in-house with using outside managers to complete a diversified portfolio
5
Active vs. Passive Management
Active Management
•Pros•Alpha Generation•Differentiate through investment performance•Differentiate through manager selection•Cons•Tracking error•Higher cost•Labor Intensive
Passive Management
•Pros•Low Cost•Low Labor Commitment•Less emphasis on performance•Cons•Virtually guaranteed to underperform benchmarks•Less ability to differentiate IM process
The decision between active and passive is not a zero-sum game. A combination of the two may be optimal. “Barbell” risk in lower-alpha categories such as LC Equity Using index funds for high-volatility asset classes such as
commodities
6
Selecting Types of Management Vehicles
Much like the active versus passive discussion, the decision between Mutual Funds and ETFs is not all-or-nothing. A firm can dramatically reduce their client’s expense
through ETFs, if passive management is preferred Attention should be paid to the tax implications of
individual ETFs as well as the potential trading costs
Mutual Funds•Pros•Large Universe•Access to many well-established managers•Still best avenue to pursue specialized active management•Cons•Higher expense ratios•Redemption fees are possible•Share class confusion•Desired fund may be closed to new investors
Exchange Traded Funds
•Pros•Low Cost•Growing market•Drawing positive media attention
•Cons•Actively managed options limited•Potential tax pitfalls (K-1s)•Tactical trading may be costly
7
How Much Style Drift is Tolerable?
Style box complexity should be scaled to the IM resources of the firm Regardless of the chosen style-box complexity, each category should
be evaluated with equal rigor and frequency Style box complexity intensifies with international equities
(Developed Markets vs. Emerging + Large, Mid, Small; Growth, Blend, Value)
Selecting appropriate benchmarks is very important A less complex style-box should lead to a shift away from category averages
to the use of broad benchmarks
Large Value
Large Blend
Large Growth
Large Value
Large Growth
Large Value
Large Growth
Large Blend
Mid Value
Mid Blend
Mid Growth
Mid Value
Mid Growth
SMID Value
SMID Growth
SMID Blend
Small Value
Small Blend
Small Growth
Small Value
Small Growth
Example of Style Categories, Domestic Equities8
Designing a Program Around Your Firm’s Resources
Necessary resources Manager Database/Analytics Software Investment Management Staffing Investment Committee to vet manager selection
To run a fund due diligence program effectively, it should be scaled to the firm’s IM resources Active Management over Passive = More Analysis More Complex Style-Box = More Analysis
Active vs. Passive decision is the key driver
9
An Example Due Diligence Program w/Examples
The due diligence process described in the next slides focuses on following categories Quantitative Analysis: Returns; Risk; Cost Qualitative Analysis: Performance attribution;
Fund Manager Investment Philosophy Final Review Ongoing Monitoring/Review
The program is designed to be consistently employed across all asset classes/investment styles
10
SUPERIOR RISK-ADJUSTED RETURNS
STYLE CONSISTENCY
LOW COSTLONG-TERM
TRENDS
What are the best funds in the asset class universe based on our metrics?
How do the best funds differ from each other?
What factors explain the best funds’ outperformance?
Is the fund manager’s philosophy aligned with the firm’s?
What are the insights/concerns of our group regarding the fund under review?
Are there under-performing funds in the portfolio?
Is this underperformance more cyclical or structural (STYLE DRIFT)?
If STYLE DRIFT is present, is it organic or synthetic?
Mutual Fund Due Diligence Process11
NEAR TERM: 1 yr returns above
Category Average
MEDIUM TERM: 3 yr annualized returns
above Category Average
LONG TERM: 5 yr annualized returns
above category average
Command Field NameOperato
rValue
Morningstar Category = Large Value
And Total Ret % Rank Cat 1 Yr <= 50th percentile
And Total Ret % Rank Cat 3 Yr <= 50th percentile
And Total Ret % Rank Cat 5 Yr <= 50 percentile
And Max Front Load = NAAnd Deferred Load = NAAnd Std Dev 3 Yr (Mo-End) <= CAT AVG
And Annual Report Net Expense Ratio <= CAT AVG
And Turnover Ratio % <= CAT AVGAnd Manager Tenure (Longest) >= 5 years
TOP SCREENED
FUNDS
Best funds in category universe
based on our metrics
Mutual Fund Due Diligence Process: QUANTITATIVE ANALYSIS
12
QUANTITATIVE ANALYSIS
Screen Group created
QUALITITATIVE ANALYSIS
Screen group parsedAttribution investigated
WILL INFORM the next phase
Name Ticker Morningstar Category
Total Ret YTD:
JANUARY 2012
Total Ret 1 Yr
Total Ret
Annlzd 3 Yr
Total Ret
Annlzd 5 Yr
Total Ret
Annlzd 10 Yr
Std Dev 3
Yr
Manager Tenure
Turnover Ratio %
Prospectus Net
Expense Ratio
Exceeds Group Avg.
MFS International Value I MINIXUS OE Foreign Large Value 1.82 -1.10 15.52 -0.12 9.28 18.38 8.33 24.00 1.03 7
Tweedy, Browne Global Value TBGVXUS OE Foreign Large Value 1.78 -3.03 16.72 -0.12 6.37 14.26 18.67 12.00 1.40 7
Thomas White International TWWDXUS OE Foreign Large Value 6.38 -6.72 16.22 -1.27 8.89 22.26 17.67 41.00 1.38 6
Manning & Napier International S EXITXUS OE Foreign Large Value 5.13 -9.99 14.66 0.69 7.90 20.61 19.17 13.00 1.11 5
JHancock3 International Value Eq I JIEEXUS OE Foreign Large Value 6.65 -9.71 17.52 -2.68 7.15 21.68 13.92 12.00 1.18 4
Templeton Instl Foreign Eq Ser Primary TFEQXUS OE Foreign Large Value 5.22 -9.45 14.18 -1.95 7.37 22.75 15.58 13.63 0.81 4
GMO International Core Equity VI GCEFXUS OE Foreign Large Value 4.02 -7.72 12.95 -3.52 7.10 21.46 10.08 40.00 0.44 1
DFA International Value I DFIVXUS OE Foreign Large Value 6.72 -14.88 16.64 -4.49 8.50 26.88 13.17 9.00 0.45 5
SCREEN GROUP AVERAGE 4.72 -7.82 15.55 -1.68 7.82 21.03 14.57 20.58 0.98
US OE Foreign Large Value Foreign Large Value 5.66 -10.41 13.13 -4.51 5.76 22.85 45.95 1.41
Mutual Fund Due Diligence Process: QUANTITATIVE ANALYSIS
13
Mutual Fund Analytics and Selection Process: QUALITATIVE ANALYSIS
14
We identified a period of sustained underperformance combined with above average risk in our Foreign LC Growth fund (BIGIX).
After reviewing the data, we linked this period of outlier underperformance to the fund’s significant OW in EM.
Once we identified this style drift into the EM space of our Foreign Large Cap Growth manager, the questions we asked ourselves:
CONSISTENT or TRANSITORY?
ALIGNED WITH OUR EXPECTATIONS FOR OUR MANAGERS?
Mutual Fund Analytics and Selection Process: QUALITATIVE ANALYSIS
15
Our next step was to identify replacement candidates in the asset class/style box under review. (UMBWX and HLMIX)
These candidates have to had made through our screen as detailed in slides 2 and 3.
We verified that BIGIX’s EM style drift could be expected to be consistent going forward, after a series of live and conference call portfolio updates with the lead PM.
We then compared the candidate funds’ historical EM weightings and current EM caps to ensure that these funds were being managed in alignment with our expectations for our Foreign Large Cap Growth manager.
Mutual Fund Due Diligence Process: QUALITATIVE ANALYSIS
16
TIMELINESS of prospective swap:• W
hipsaw risk?
• How does current Market and Sector environment affect the swap?
POTENTIAL QUESTIONS and QUALMS:• F
rom Clients
• From Investment Committee
GROUP KNOWLEDGE:• E
xperience with Fund Company
• Previous experience with similar swap/shift
MISCELLANEOUS:• D
erivates usage?
• Trading structure
• Sell Discipline
INTERNAL GROUP DISCUSSION
Q&A with Candidate
Fund PM team
Mutual Fund Due Diligence Process: FINAL REVIEW
17
EXPLANATION OF OW/UW’s:• C
yclical or Structural?
• OW/UW’s Attribution?
RESPONSIVENESS of PM team• D
o we have direct access to actual PM?
REQUEST COMPARATIVE ANALYSIS with CURRENT FUND• S
ector weights, Returns, Risk
CASH ALLOCATION• T
actical or Fully Invested?
Q&A WITH CANDIDATE FUND
PM TEAM
IMPLEMENTATION of INVESTMENT
DECISION
Mutual Fund Analytics and Selection Process: FINAL REVIEW
18
Asset Management & Trust Group
Featured Mutual Funds (Extract)1/31/2012
Page 1 of 2
Name TickerYTD
Return1-yearReturn
3-yearReturn
5-yearReturn
10-yearReturn
Std Dev 3yr
Manager Tenure
Turnover Ratio
Expense Ratio
Large Cap Equity
Fidelity Advisor New Insights FINSX 4.91 3.53 18.37 2.82 15.67 8.58 47.00 0.89
Category Average: Large Growth 6.31 1.83 19.73 1.60 3.14 19.09 73.65 1.32
American Beacon Lg Cap Value Inst AADEX 4.95 -0.16 18.19 -1.55 5.42 20.22 24.58 90.00 0.60
Category Average: Large Value 4.27 1.23 17.06 -1.46 3.87 18.96 61.14 1.25
S&P 500 4.48 4.22 19.24 0.33 3.52 18.16
Mid Cap Equity
T. Rowe Price Mid-Cap Growth RPMGX 6.20 2.47 26.56 6.23 8.54 19.86 19.67 30.10 0.80
Category Average: Mid-Cap Growth 6.79 1.19 23.33 2.73 5.40 20.93 87.94 1.40
JPMorgan Mid Cap Value Instl FLMVX 4.04 5.39 22.07 2.42 9.17 18.69 14.25 41.00 0.76
Category Average: Mid-Cap Value 5.74 -0.46 22.27 0.41 6.52 21.63 58.10 1.34
S&P MidCap 400 6.61 2.71 25.26 3.90 7.78 21.68
Monthly Review
of Screen Metric
data
Do we see RECURRING relative underperformance?
Is the RECURRING
relative underperfor
mance improving or worsening?
Is there NEW
relative underperformance?
Mutual Fund Analytics and Selection Process: ONGOING MONITORING/REVIEW
19
SUPERIOR RISK-ADJUSTED RETURNS
STYLE CONSISTENCY
LOW COSTLONG-TERM
TRENDS
Do we see RECURRING relative under-performance?
Fund put on watch listIn-depth review tabled
Do we understand the under-performance as
cyclical and expected for what we selected the
manager to do?
NO?
YES?
Mutual Fund Analytics and Selection Process: ONGOING MONITORING/REVIEW
20
Final Thoughts
Mutual Fund due diligence is critical to the role of fiduciary
The process, and the overall investment program itself, should be tailored to fit the level of resource committed to the investment function
A well documented and consistent review process can be a major selling point to prospective clients Altering the perception of “outsourcing” to one where
the firm is actively “managing” its managers
21
MUTUAL FUND DUE DILIGENCEPresented to FIRMA By R. James Hrabak, CFAMarch 28, 2012