As more and more wealth managers turn to independence to run practices in ways they believe are better for their clients and themselves, some, used to the infrastructure of large firms, become overwhelmed at the thought of performing the research and due diligence tasks that clients—and regulators—demand. But firms that serve these wealth managers are wise to this, and are offering ways to outsource important functions—such as the chief investment officer.
Not only are smaller registered investment advisors (RIAs) looking to outsource these functions; it’s also a trend in single- and multi-family offices and larger brokerage firms and banks.
“Prima Capital serves as the outsourced chief investment officer to a number of big banks and brokers, according to J. Gibson Watson III (left), president and CEO of Denver-based Prima Capital, a firm known for its deep research bench and due diligence on SMAs, mutual funds, ETFs and alternatives.
At a time when Watson says firms are re-examining their best practices when it comes to research and due diligence, his firm’s deep bench of analysts provide independent research, due diligence, allocation models, recommendations and manager monitoring on a subscription basis.
The Research Process
Prima Capital’s team collects” individual securities holdings for the portfolio,” to look at “returns-based analytics” and “conduct extensive holdings-based analytics on that particular manager,” says Watson.
Prima Capital looks at four “style sub-factors” when evaluating a manager’s style:
- A single-factor regression analysis
- A multi-factor regression analysis—returns based
- A holdings-based style analysis
- Manager’s discipline
The firm uses the individual securities holdings data it captures for holdings-based style analysis, displaying “each individual security in the portfolio on a bi-metric grid, plotting market capitalization on the vertical axis, and security characteristics on the horizontal axis, and you’ll see this scatter gram so that you can get a sense, at a point in time: How are the individual securities in the portfolio aligned, market cap versus security characteristics. So you can see what’s going in at the portfolio level.” This “x-ray into the portfolio,” notes Watson, provides a “much better sense of the actual risk that’s going on at the portfolio level, for that particular manager.”
The Qualitative Deep Dive
Then, they look at the manager’s discipline and whether that “makes sense in terms of how they’re buying stocks—and is that presented in the holdings in the portfolio and further supported by the single-factor and multi-factor regression analyses that we’ve looked at over time.”
Each quarter, Prima analysts take month-end data and conduct a “holdings-based performance attribution analysis on the manager, and there we decompose the attributes of performance to tell us how much of the manager’s return that quarter was generated by the asset allocation, sector selection, security selection, or by the market timing and trading components.”
For example, for a “U.S-based large-cap, bottom up fundamental” manager, they would “expect to see the bulk of that manger’s alpha being generated from their stock-selection capability, and secondly from their trading expertise,” Watson asserts. “In small-cap managers, where the markets are more inefficient than in large caps, we tend to see managers who add more value from market timing and trading expertise.” The analysts look to see if what they expect is what the holdings-based analysis shows.
“It tends to raise some red flags here at Prima if we don’t have some consistency and uniformity in terms of the manager’s investment process, and their philosophy—the whole discipline with which they’re managing the portfolio—with what we see in the quantitative data, particularly in the holdings-based performance attribution side of things,” Watson argues.
Looking at the Big Picture
A lot of advice is “not necessarily recommending a mutual find or a separate manager in a vacuum, but [advisors] positioning their value add as starting with asset allocation that is appropriate, and in the best interest of the investor. After you get that asset allocation established—then the job is selecting the appropriate asset managers to implement each sleeve of the portfolio.” But, Watson notes, “If you just look at returns coming from the manager, you’re going to miss the big picture.”
These advisors, who work with clients on a “holistic basis,” want to see how the managers “play together at the security level: Do I have evidence of a vacancy in my portfolio design [or] redundancy and overlap in other areas—and what does this do to the risk parameters around the portfolio that I’m constructing for my client?”