Switching investment managers

• buy discipline: knowing when and at what price to hire the manager;
• ongoing evaluation: how to monitor the manager effectively; and
• sell discipline: knowing when to terminate the manager.

While switching investment managers is not a task that can be outlined upfront with clearly delineated if/then scenarios, establishing a baseline process for terminating a manager acts as a guide to keep the pension committee on track and avoid going off on tangents.

Committees often get caught up in the gravitational pull of investments. A good place to outline the reasons supporting manager termination is in the Statement of Investment Policies and Procedures (SIP&P), which will be aligned with the pension plan’s unique objectives and basic governance process.

It is important to note that active managers naturally underperform at various points in a market cycle. The reality is that any trade comes with risk—the manager’s performance in one cycle might not be indicative of overall performance, which might bounce back later. For this reason, a trend analysis is key in helping committees make decisions. This analysis comprises both traditional analysis of performance, portfolio, people and philosophy/process —the four Ps—and a common sense overlay.

The four Ps

1. Performance
Past performance does not guarantee future performance. But it is generally a pretty good indicator if the performance analysis is supported by the following characteristics:

• attribution analysis clearly verifies how the performance was produced;
• performance remains attractive after fees; and
• periods of underperformance and outperformance are understandable relative to the markets that produced them.

2.  Portfolio
Policies and procedures to construct and maintain the portfolio should be clear, in terms of risk management and monitoring; quality controls and style adherence; capacity for assets under management; and the use of “soft dollars” (i.e., expenses, typically for research, paid for from brokerage commissions).

3.  People
Understand which people are critical to the success of the investment process and how the operating structure optimizes the performance of the team, including ownership, team, key investment professionals, and evolution (especially through retirement) versus “free-will” decisions to stay or go.

4.  Philosophy/Process
Know the process to identify and evaluate potential investments and construct portfolios, including buy/sell disciplines and portfolio construction.

By putting the four Ps trend analysis into action, the committee will arrive at three possible actions for the manager: retain, review or terminate (see chart below).

Common sense overlay
At any point in the process, the pension plan committee should be able to answer affirmatively to these four questions:

1. Would the committee hire this manager today?
2. Does the manager have the ability to align with the pension plan’s mission and partner with the committee to work toward that mission?
3. Does the manager have a clear and prudent asset growth strategy?
4. Does the manager have a clear policy for maintaining and enforcing business ethics and integrity?

If the answer to any of the above questions is no, then the committee has a clear indication to terminate the manager.

Manager search process
If the committee decides to terminate the manager, then the next step is to search for a replacement. Assuming no other changes in manager structure, the committee undertakes a search and selection process with specific criteria. This buy decision should be based on complete and current information. Where appropriate, the committee should seek advice from independent qualified experts before making a decision.

Developing search criteria
This first step is the most important in the process, as it defines the mandate and establishes the criteria for ongoing review and even potential future termination. What are the key factors that, if they were to change, would be cause for termination?

Alternative products have additional risk characteristics—i.e., financial risk, information risk, liquidity risk, business risk and monitoring risk—which should be incorporated into the search and selection process. These added risks warrant the expectation of higher returns versus traditional asset classes.

Search report
This detailed due diligence report highlights the strengths and weaknesses of each candidate in terms of organization, people, investment process, investment style, portfolio attributes and investment performance.

Candidate interviews and decision-making
Typically, a pension plan committee will interview three or four finalists and then make a hiring decision. A manager scorecard based on criteria and interview experience may be helpful.

Investment manager agreement
Review and finalize this agreement with the new manager.

SIP&P
This document should reflect all key investment decisions that the committee makes, including any change in fund structure or managers. The new manager will be required to acknowledge receipt of the SIP&P and confirm in writing that it intends to manage the assets under its administration in accordance with it. If the use of a pooled fund conflicts with the SIP&P, the manager is expected to communicate with the committee on when and how the pooled fund investments differ from the guidelines in the SIP&P, including an explanation of the perceived risks/benefits to the pension fund. The committee may then provide appropriate direction.

Termination and transition process
Notify the incumbent manager and custodian/recordkeeper of the termination, and develop a project plan for the timing of the transition. Provide both the incumbent and new managers with the transition details and dates.

Switching managers shouldn’t be an offhand decision. But, with the right process in place for pension  committee members, it shouldn’t be an onerous task.

Peter C. Arnold is national practice leader, investment and CAP consulting, with Buck Consultants, A Xerox Company. peter.arnold@buckconsultants.com

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