Money Manager Due Diligence Scott Thoma CFA The

Money Manager Due Diligence Scott Thoma, CFA

The Challenge § > 7, 000 Separately Managed Account Options § > 7, 000 Distinct Mutual Funds (> 25, 000 when incorporating share classes)

The Challenge § Investors judge on short-term performance § Fiduciary duty? § Urge to "do something"

How Do You Conduct Manager Screens? § 4 P's § Performance

How Do You Conduct Manager Screens? § 4 P's § Performance § Historical § Risk-adjusted § Star rankings § People § Philosophy § Portfolio

Mutual Fund Selection Process Universe (7, 000+ Funds) Target Universe Identify managers with records of performance success Rolling period performance Risk-adjusted performance Performance Attribution Evaluate factors leading to success People Process Portfolio characteristics Judge whether success is repeatable Selection • Investment thesis • Team discussion Removal List of Approved Managers • Change in thesis • Better alternative

Manager Initiation - RFI Process § Personnel - Changes in structure, coverage, resources § Process § Portfolio structure & philosophy § Ownership

Qualitative Analysis § Level of experience § Key decision makers § Resources § Performance and financial incentives

Qualitative Questions § How does the portfolio management team identify attractive investment ideas? § How does the investment team build the mutual fund portfolio? § Does the investment process make sense? § Is the overall investment process repeatable?

Investors Chase Performance Source: Ned Davis Research, Inc.

Rolling Period Analysis – Fund A § Morningstar Rankings (end of 2008) § 1 -Yr: 97 th Percentile § 3 -Yr: 96 th Percentile § 5 -Yr: 91 st Percentile § Rolling Period Return Analysis § Fund outperformed its benchmark and peers in 88% and 99% of 5 -year rolling periods, respectively. § Outperformed its benchmark and peers in 76% and 86% of 3 -year periods, respectively. § 10 -Yr Morningstar Ranking: 9 th Percentile Source: Morningstar

Portfolio…Or Collection of Funds Source: Morningstar

Differences in Styles Leads to Differences in Performance Fall/Winter 2008 Spring/Summer 2009 Deep Value Underperforms Deep Value Outperforms Eclectic & Conservative Managers Outperformed High Quality Underperforms

Understanding Fund Differences International Fund Performance Differences § Emerging markets allocations § Currency hedging

Importance of Understanding Fund Differences Source: Morningstar

Even Top Managers Endure Tough Times Periods of Relative Underperformance vs. S&P 500 Rolling 1 -Year Periods Top Quartile Managers Q 1 1998–Q 4 2007 Past performance does not guarantee future results. Universe—Large-Cap domestic equity; 164 large-cap managers whose 10 year average annualized performance ranked in the top quartile from January 1, 1998– December 31, 2008 were analyzed. Source: Factest, PSN and Alliance. Bernstein

Even Top Managers Endure Tough Times Periods of Relative Underperformance vs. S&P 500 Rolling 3 -Year Periods Top Quartile Managers Q 1 1998–Q 4 2007 Past performance does not guarantee future results. Universe—Large-Cap domestic equity; 164 large-cap managers whose 10 year average annualized performance ranked in the top quartile from January 1, 1998– December 31, 2008 were analyzed. Source: Factest, PSN and Alliance. Bernstein

Even Top Managers Endure Tough Times % whose Rolling 1 -Year Performance Fell into the Bottom of the Rankings Top Quartile Managers Q 1 1998–Q 4 2007 Past performance does not guarantee future results. Universe—Large-Cap domestic equity; 164 large-cap managers whose 10 year average annualized performance ranked in the top quartile from January 1, 1998– December 31, 2008 were analyzed. Source: Factest, PSN and Alliance. Bernstein

Consistent Performance Is Elusive: Even Top Managers Endure Tough Times % whose Rolling 3 -Year Performance Fell into the Bottom of the Rankings Top Quartile Managers Q 1 1998–Q 4 2007 Past performance does not guarantee future results. Universe—Large-Cap domestic equity; 164 large-cap managers whose 10 year average annualized performance ranked in the top quartile from January 1, 1998– December 31, 2008 were analyzed. Source: Factest, PSN and Alliance. Bernstein

Detailed Performance Review § Peer review § Attribution analysis § Drift

Drivers for Removal § A significant negative change to the fund's portfolio management team § A significant change to the fund's investment process § Investment style or investment process drift § A better alternative within the same asset class § Underperformance (relative to style and process)

Issues With Star Rankings § Portfolio/Style Bias § Short-term Performance Bias § Share Class Bias § Category Changes § Manager Changes

Issues With Star Rankings § Not predictive of future performance “In short, the star rating is a backward-looking measure of past performance. What it is not is a forward-looking measure of fundamentals. ” - Russell Kinnel, Morningstar

Regulatory Issues § Fiduciary Standard § Target date funds § 12 b-1

The Challenge § Number of options § Evaluating performance § Urge to "do something" § Time / resources

The Opportunity § Standard process for evaluation § Better decision making process § Better portfolios § Better client experience

Questions / Comments?