By: Matt Garrott
By: Dan Shomper
Asset allocation may account for the majority of an investment portfolio’s returns, and we are big believers in indexing in certain asset classes, but that doesn’t mean that money manager selection is an afterthought. There are too many options available to simply throw a dart at the board. As of 2022, there were about 7,400 different mutual funds available for purchase. That’s a big dart board. Like other wealth management concepts, having a process for choosing investment strategies is key. Fairway’s process has three parts: Quantitative, Qualitative, and Collaborative. Put another way: Science, Art, and Experience.
Quantitative
The science section of our manager selection process is numbers-driven. Using a program called YCharts, we start with a universe of managers in a particular asset class. Our initial screen looks at metrics such as expense ratio, manager tenure, assets under management, and performance. These metrics are weighted and scored according to what is important to us. Part of our wealth management philosophy is “control what you can control” so lower expense ratios contribute more to a fund’s score than short-term performance, for example. The funds with the highest scores are put on a list for the next step of the process.
Qualitative
If investing is part art and part science, this is the art piece. The initial screen provides us with a list of about a dozen managers. We remove funds that are clearly a poor fit – funds with recent manager changes, high fees, or low assets under management. Then we compare the funds on risk metrics, drawdowns, and capture ratios.
Once we have a handful of strategies to compare, we reach out to the money managers for information on their investment philosophy, buy/sell process, risk management controls, and holdings. We meet or have a video conference call with the money manager or a fund analyst for more color.
We pay close attention to each strategy’s investment process. Do we understand it? Does it make sense? Is it repeatable? What does the stream of returns look like? Did they just get lucky one year? Have returns kept pace with a growing asset base? Using the Report Builder function in YCharts, we then compare the funds side-by-side. Two or three funds will make it to our next step.
Collaborative
This is the human experience element of the process. We’ve been investing on behalf of wealthy families for decades across multiple investing environments. We’ve seen recessions, 50% drawdowns, zero percent interest rates, 9% inflation, a tech bubble and bust, value regimes, growth regimes, peak oil, a pandemic, and the Magnificent 7. The Investment Department leans on this experience by bringing their findings to the Investment Committee which meets quarterly.
While we share an investment philosophy, we have different perspectives and investing experiences. The team discusses the funds from a portfolio construction standpoint. A fund’s returns may look good, but does it really fit a gap we’re looking to fill? Is this strategy a case of the tail wagging the dog (chasing tax advantages, yield, etc)? Does the strategy add value to a diversified portfolio?
Watch List
Manager selection isn’t just about finding new funds. There are sometimes circumstances that require closer scrutiny (going on our “Watch List”) or even removal from the Approved List altogether. A fund warrants removal for three primary reasons:
- Poor performance relative to its peer group
- A change in the fund management
- A change in the fund’s investment process or mandate
We are purposefully slow to remove funds as occasional underperformance is a natural part of investing. However, if a fund’s performance compared to its peers falls in the lowest quartile of its category over 3-, 5-, or 10-year periods, the fund is placed on the Watch List for removal. Similarly, should a fund fail to meet one of the initial criteria, such as three years of manager tenure or adequate fund size, it is also considered for removal. After four quarters of continued underperformance or uncertainty at the fund level, the investment committee votes on final removal from the Approved List.
It’s worth noting that removing funds from individual portfolios is less straightforward in practice than removing funds from our Approved List. Tax consequences (i.e. realizing large capital gains) or lack of alternatives (such as in an employer retirement plan) can make the decision more complex and unique to each client’s situation.
Annual Deep-Dive
Given the above processes, we aim to have few removals or additions throughout the year. We spend the majority of our time keeping up with the funds that are already approved. We meet with representatives of each fund company for regular updates on fund performance, internal changes, and upcoming changes that we should be aware of.
Since we focus on controlling what we can control, we also conduct regular share class reviews to be sure our clients are invested in the lowest cost version of each fund available to them.
Annually, we review the fund companies as a whole, including diving into their company-level documents. Have there been changes to the owners of the company? Have any code of conduct violations taken place? These items can seem far removed from the performance of a fund or the decisions of a fund manager, but can impact the future of fund companies and their staying power.
The End Result
The objective of our process is to assemble and maintain an “Approved List” of strategies that our wealth management team uses to construct client portfolios. There are about 120 unique funds on this list at any given time. Each fund has been vetted by the investment research department, approved by our internal Investment Committee, and are routinely re-evaluated to ensure they remain appropriate for our clients. The manager selection process isn’t a unique event, but a rolling due diligence cycle.
