A fact of life in active asset management is that management changes take place on a regular basis. Two reminders of this fact include fixed-income manager Jeffery Gundlach’s departure from Trust Company of the West (TCW) and more recently, Richard Glass’ departure from Morgan Stanley Investment Management. Given the unpredictable nature of some manager changes, this disruption can’t be avoided altogether. However, certain aspects of a comprehensive due diligence process can anticipate personnel stability in the roster of managers that advisors rely upon. Indeed, there are even some firms that keep their managers and strategies intact for years, even decades.
The goals for any due diligence process are to identify quality management teams or individual managers who display an investment edge and deliver consistently positive alpha performance. The keys to this process are to attempt to differentiate between luck and management skill, and to select those managers whose past performance is both repeatable and sustainable in the future. For these reasons, the initial and ongoing due diligence on any separately managed account (SMA) product or mutual fund should include an understanding of the firm’s structure, compensation and incentive programs, the investment professionals’ commitment to the organization and the organization’s management succession plan.
Before we address manager changes, let’s first consider organizational changes, such as corporate mergers or acquisitions. In this event, ownership changes must be understood in detail, though the detail needed may not be made available to the public. In particular, the removal of equity ownership from the investment professionals is rarely a positive development. Equity ownership, stock appreciation rights and related profit sharing are clearly large incentives for any management or investment team. Part of the assessment should also proactively assess how the firm evaluates the next generation of management, develops the career paths of these professionals, assigns increasing levels or responsibility, utilizes peer-to-peer employee performance reviews, and what the impact on corporate culture and investors may likely be.
Following a manager change, the decision to allow client capital to remain with the asset management firm is based on many factors. Importantly, advisors should assess how the portfolio structure may change, how the buy side and sell side discipline may change, whether risk controls on the portfolio may be modified, and how those prospective changes would disrupt the client’s asset allocation. While understanding the resum? of a new portfolio manager is important, often the new manager will be well qualified and have significant experience (except in very rare cases).
Of immediate concern, however, is the near-term impact that the new manager or management team will have on the portfolio. Are there any anticipated increases or decreases to the number of securities in the portfolio or the annual rate of turnover going forward? Does the new portfolio manager intend to stress one or more of the previous manager’s key investment themes or criteria, and if so, will it change the dynamics of the portfolio as a whole? Will there be new security valuation, portfolio characteristic or risk measurement models or filters employed as part of the process?
A new manager or team often makes many of these changes as a way to “fix” perceived problems. While many of these adjustments may be long term improvements, they also impact the overall portfolio and should be evaluated carefully within the context of existing client portfolios. The number of securities in the portfolio, turnover, and sector and industry exposure will be the first indicators of major style and process changes.
In many cases, the disruptions will appear to be relatively minor. Typically, the new portfolio manager has been working on the product for years already, either as a co-manager or a senior analyst who has been groomed for just this possibility. In these simple cases, advisors and investors are generally comfortable giving the new manager six to nine months to prove their skills.
In More Complex Circumstances
It becomes much more problematic when the succession plan is vague or when an entire team of investment professionals leave or are lured away from a firm. In many of these cases it is difficult, at best, to fully measure the degree to which the management change will impact the portfolio going forward. In most of these cases, the prudent course may often be to move assets to a firm with a more readily identifiable and consistent investment style and process.
Wealth managers need to dig deep, ask pointed questions, and make informed decisions whether they are faced with an organizational change or acquisition, a manager change through succession, or a mass departure. Besides evaluating the new manager’s qualifications, don’t forget to consider the impact on the portfolio and how those changes are manifested in your carefully designed asset allocation strategy. No matter the situation, it is always important to understand a firm’s structure and incentives for keeping a portfolio manager or management team in place. In these instances, be sure to recall the time honored clich?: let the buyer (and advisor) beware.
J. Gibson Watson III is president and CEO of Denver-based Prima Capital, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.