Adopting this approach means that the plan sponsor must define risk in a similar manner to the investment manager, but also ensure that the definition is consistent with the plan’s objectives. The plan sponsor should be able to set a risk budget and translate that amount into terms understandable by the investment manager. Specifically, the investment manager should know the acceptable level of total dollar risk budgeted and the relative risk permitted for the portfolio, identified in terms of volatility or other risk measures pertinent to the client. The plan sponsor should define acceptable performance targets and variances, including outperformance frequency.
If the Style Fits… Investment managers use a variety of different strategies or styles to analyze equity investment opportunities and determine their potential. Here’s a quick overview of some commonly used terms and the strategies they describe. Fundamental or bottom-up portfolio managers emphasize individual company analysis. They examine, in detail, a company’s financial information and performance, as well as its business strategy and management team, to determine how its stock might behave in the future. Top-down managers place greater emphasis on macroeconomic forces and data. They scrutinize the global, regional and sectoral forces shaping the financial performance of individual companies, looking to capitalize on the investment opportunities in the businesses best placed to take advantage of these larger trends. Value managers look for companies that they believe have been mispriced by the markets and will rise in value in the future. These managers look for stocks that have been driven down, for example, by broader market swings or bad economic news, but which are backed by solid businesses that the manager believes will recover and appreciate in value over a longer time horizon. Growth managers look for upside opportunities. They are less concerned about the fundamental value of a company or its current stock price than its potential to achieve future growth, due to either market momentum or its particular business strategy. Quantitative managers focus less on detailed analysis of an individual company’s fundamentals, management and business strategy and more on the quantifiable factors that will affect its stock performance. They look for predictable indicators that a company’s stock will rise and invest where the quantitative data show the greatest potential for appreciation. |
Using these measures is a best practice for investment managers, but plan sponsors must also ensure that managers understand the use and importance of these measures and do not simply compute them. A manager needs to incorporate risk forecasts into the current portfolio and monitor the actual risk levels experienced to ensure consistency. And the plan sponsor should request proof that the manager is capable of delivering on the risk estimates.
Attribution and adherence – Plan sponsors should contract with their investment managers to deliver alpha, beta or both types of return, per the investment management agreement. In addition, they should demand that managers attribute their successes or failures to ensure that they are earning return appropriately. Managers should be able to prove that the added value and the manager style are aligned.
Trade cost analysis and execution strategies – How trades are executed can affect returns, so firms are developing new strategies to understand the expected costs and risks of trade execution. Technology can help managers affirm compliance to mandates. It can also help assess trading liquidity in order to develop advanced strategies for executing trades. There is a cultural shift in the works—from viewing traders as executors of orders to seeing them as key strategists in the investment process.
Trading best practices rely heavily on the use of transaction cost analysis (TCA). TCA should be used before the trade to understand the expected costs and risks. This pre-trade TCA should be used in selecting the trading benchmark, the level of trade urgency and the trading method, whether it is direct market access, algorithms (electronic access directly to the exchange), principal trading (in which the broker provides capital to get the trade done) or traditional agency trading (in which the broker finds another client to complete the transaction). TCA can be used while the trade is being executed to ensure that transactions, regardless of the trading method, are being done in adherence with the trading strategy. Furthermore, post-trade TCA is necessary to evaluate the overall performance of traders, algorithms and brokers, as well as the quality of the pre-trade cost and risk estimates.
Having the technological ability to access all sources of trading liquidity is a best practice. These sources can include alternative trading systems, dark pools (regulated client-to-client trade-matching systems) and traditional markets. Plan sponsors should expect to see trade implementation strategies being used to control transaction costs.
Mandate governance and risk culture – Mandate governance practices are designed to avoid unexpected outcomes. However, the success of these practices depends on the integration of a strong risk culture. A risk culture is enhanced by the presence of several factors. For example, the company needs to communicate to all departments and staff the importance of risk management as a primary fiduciary duty. The ultimate best practice will generate a firm-wide understanding of the relationship between risk and return, and how proper management can enhance investment decision-making.
All investment management firms must strive for strong process standards in order to be successful, so it’s unlikely that true differentiation will be achieved at the process level. Instead, plan sponsors should look for differentiation at the cultural level. Best practices aren’t the only requirement for a productive plan sponsor/investment manager relationship, but implementing a culture that promotes these practices will help ensure the relationship’s success.
Jeff Brown and Doug Crocker are principals with Highstreet Asset Management. brownj@highstreet.ca; crockerd@highstreet.ca
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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the August 2008 edition of BENEFITS CANADA magazine.