Consultants and Investors are Digging Deeper into Data

Today, one of the major keys to success in the investment management business is risk management. Wall Street has numerous ways of describing risk. Here are just a few:

- Headline Risk: Will my board read something bad about my manager in the paper?
- Tracking Error Risk: How far away from the benchmark can I expect this manager to be?
- Talent Risk: What is the probability that a firm can retain good talent?
- Business Risk: Will the investment manager be around next year?
- Enterprise Risk: Will my company be around next year?
- Concentration Risk: Do I have too much money with this manager or within a given strategy?
- Funding Risk: What is the probability that my defined benefit plan cannot pay my retirees?

Consultants and plan sponsors are far more interested in these questions than they are in performance or style. Why? After two decades of comparing and studying performance and style, the tools for analyzing these two aspects of investment management are very well developed. Investors are comfortable that performance numbers claiming GIPS compliance are likely to be accurate.

Holdings-based and return-based analytical tools can reveal whether a manager is really a large cap value manager or a large cap core manager. Investors can measure performance and style against a variety of benchmarks using a variety of online tools or with the help of their consultant.

Currently, traditional institutional asset management firms submit performance and holdings data to as many as 30 different databases without thinking twice. That was not the case 20 years ago. Back then, it was not unusual to find a few portfolio managers who refused to disclose assets under management, holdings and monthly performance because it was too much of a nuisance. In addition, it did not reveal the more important aspects of product and philosophy.

Today, we see portfolio managers who are still reluctant to disclose certain types of information. Largely banks or insurance-affiliated organizations are reluctant to release compensation or employment contract information because they think it threatens the compensation structure of the larger firm.

Hedge funds are fighting transparency - disclosing holdings or portfolio profiles - because they think the edge they are exploiting will be taken away by competitors copying their styles. Both perspectives have merit but they have to be weighed against the realities that face today's investors. That means understanding the buyer's concerns about risk.

The first three risks described above are directly related to investment managers. We'll discuss those here.

Headline Risk

This is the single most crucial factor that an executive director, board of trustees or consultant assesses when deciding to hire or recommend an investment manager. Most RFPs and databases now include these questions:

- Describe your compliance process.
- Describe your trading practices.
- Does your performance composite comply with GIPS requirements?

It is very easy to screen out managers who do not have the right answers to these non-investment related questions.

For hedge fund managers, headline risk is mitigated - in the plan sponsor's mind - by transparency. While the most sophisticated hedge fund of funds will confess that transparency provides little in the way of being able to insulate an investor from improprieties, it does address one important buying criterion of plan sponsors: comfort.

Hedge fund of funds serve two purposes. First, they allow smaller institutional investors diversified access to this asset class. Second, they are a ready market for individual hedge funds to gain distribution. The price of that distribution channel is transparency - showing what is held, how it is priced, when it is traded along with the profile of the fund.

Fund of funds and an increasing number of direct investors require and are able to get transparency from hedge fund managers.

Tracking Error Risk

Risk budgeting is the practice of setting and monitoring how far a plan can stray from its projected benchmark returns and what latitude managers will be given in allowing them to stray from their assigned benchmarks. In order to implement risk budgeting, plan sponsors and their consultants need to know detailed historical data on performance and holdings from managers whose asset classes are regularly priced. While this includes hedge fund managers, it does not include other asset classes such as real estate, private equity, oil & gas and timber.

If you want to play in the institutional arena, performance and holdings are a must. If you are pursuing high net worth clients, this information may be optional, for now. With the increasing availability of online risk management tools, the day is coming when most investors will be able to tell you the exact tracking error risk in their portfolios in much the same way they can tell you their daily results.

Talent Risk

Institutional investors are particularly apprehensive of personnel turnover. There is no guarantee that the manager or team responsible for generating the performance that got a firm hired will remain on staff.

In order to get some comfort with regard to this type of risk, investors now ask the tough questions:

- Will this team stay with your company over the long term?
- Describe your compensation packages.
- Tell us about the ownership structure.
- What is your succession plan?

Before you dismiss these answers or give them little consideration, remember that your competitors are using every answer in an RFP as a way to distinguish themselves and present the case that they are the right manager for the prospect.

Put yourself in the client's shoes for a moment. If you have ever had to change accountants or attorneys, you know that personnel turnover is arduous. In addition, it is expensive to swap one manager for another when you consider the cost of the search and transition commission expense.

Bottom line - full disclosure is in fashion. It is the latest in screening techniques. If investors or their consultants sense that they might be dealing with unexpected surprises during the course of a relationship, they will quickly move on to the next candidate.