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Kindred Spirits

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In the nearly 30 years that I have been covering financial advisors, the fundamental problem hasn’t changed: Delivering client-centered advice isn’t as profitable as selling products. Consequently, independent RIAs don’t get much respect, or at least, not nearly the respect they deserve. Fund companies prefer to focus on wirehouse and other broker distribution channels. Congress inexplicably has concluded that RIAs (rather than non-fiduciary brokers) need more regulation, and even most custodians that serve them seem to have a hard time committing to the RIA market.

With this conundrum firmly in the back of my mind, I was pleasantly surprised to find recently that American Beacon Funds was still among the handful of investment companies that consider independent RIAs as one of their core markets. This was particularly amazing considering that three years ago the  pension fund manager brought in a big-time investment company executive as its new president and CEO, which, in my experience, is often an indicator of a firm’s intent to move beyond the RIA channel.

But Gene Needles isn’t your typical investment company exec. To be sure, he’s got the credentials: In his nearly 30-year career prior to taking the helm at American Beacon, he’s served as vice president at Putnam Investments and Metlife State Street, president of Touchstone Investments, and president and CEO of AIM Distributors. Perhaps due to his broad experience, Needles doesn’t seem to suffer from the “bigger is better” prejudice that’s so common in the financial services industry. In fact, he’s developed a unique perspective on the industry, one that has undoubtedly contributed greatly to his success.

“We look at the RIAs as a single firm so we can see how much biz we’re getting from that channel,” he told me. “If you don’t look at them collectively, the RIAs will pale in comparison to large retail and institutional outlets. But they are plenty big when you add them all together in the same way other firms look at, say, all the Merrill branches.”

Playing off its roots as the manager of American Airlines’ employee pension fund, American Beacon has historically attracted the majority of its assets—about 75%—from retirement plan platforms. The remaining 25% came from independent RIAs. As you might expect, Needles has worked to diversify the company’s distribution beyond those two channels. “Now we’re seeing a better balance in our assets,” he says, “with 40% coming from retail outlets. Still, the two hardest spaces to penetrate are the RIA and retirement markets. It’s a great biz, and we don’t want to forget about it.”

In addition to a healthy respect for their business, the firm has something else in common with RIAs: expertise in selecting and monitoring investment managers. While it’s recently added a few single manager funds, American Beacon’s stock in trade is combining big-name, high-minimum institutional investors into funds that are accessible to advisors’ clients and participants on pension platforms.

In more than a quarter century of analyzing, selecting and monitoring some of the world’s best investors from an institutional perspective, the American Beacon team has become pretty savvy about how to put together and manage multimanager portfolios. Needles candidly points out four key mistakes that advisors and other professional investors often make, usually to the detriment of their portfolio returns—and their clients’ success:

Treating retail investors as if they are institutional investors. Needles believes that using style-box asset allocation in the retail market has been a major mistake on the part of financial advisors. “I think we’ve seen a move away from category asset allocation,” he says. “The problem is that it treats retail investors as institutional investors. Even if we take the emotion out, they are still different. Their time horizons are different, and they can’t diversify nearly as much. Consequently, they can’t weather the downturns. I think that’s why we’re seeing a lot of advisors going back to objective-based investing rather than benchmarks.”

Focusing on returns rather than risk. “Our concentration,” says Needles, “is on reducing risk. As fiduciaries, our job is making sure that the returns we get in our portfolios are the returns that our investors get. The ability of investors to stay with funds is at least as important as the performance of the managers. If you can’t mitigate some of that volatility, they won’t stay with you, and you won’t be able to deliver consistent performance.”

American Beacon’s funds reflect this risk orientation. On the equity side, returns virtually mirror the funds’ bogey indexes, with standard deviations over the past three years of between 13.3 and 26.6 and sharpe ratios hovering around 1.

Over-engineering. In most of its funds, American Beacon uses a multimanager approach, similar to the way many advisors construct their portfolios. Yet many of those portfolios don’t match that of American Beacon or some other institutional managers. “Why hasn’t multimanager performance been better?” asks Needles. “I’ve thought about that a lot. Many of those guys are really smart. They have very sophisticated equations based on correlations and expected rates of return. Then you look at the performance. What’s the problem? Overweighting allocations to certain managers. If you overweight, you transfer the risk to the person who’s doing the allocating. They’ve then become the manager with the single biggest risk. There is a danger in this business of over-engineering portfolios. The whole idea is diversification. They’ve forgotten the underlying premise.”

In contrast, American Beacon tries to equally weight its funds across all the subadvisors. “Our goal is to spread the risk out equally to all our managers,” he says. “We think the idea is to avoid putting all your eggs in one basket.”

Replacing managers too soon. According to Needles, this is the biggest error portfolio managers make. It’s human nature to want to “do something” when a manager or an entire portfolio is underperforming. Unfortunately, knee-jerk reactions often lead to missing the rebound. “Even institutional managers get it wrong with replacing managers,” says Needles. “They do it at the wrong time; then the managers tend to outperform after they are replaced, and the replacements tend to underperform. We’re very patient when it comes to disappointing performance, but we’re always ready to act quickly when it is time to make a change.”

How do they decide when the time is right? “We try to determine if there’s been a fundamental change with the management team,” he says. “We look at whether the discipline has changed; whether we still believe in that discipline; if they’ve changed their [tactic]; and did they recently lose any managers or have any turnover in the past couple of years. But when it’s time to act, we act. We’ve changed managers in just 24 hours when we felt we needed to. Once, for instance, the lead manager left one of our subadvisors. We knew he was calling the shots, so we replaced him.”

To find new managers, American Beacon looks for a team approach to investing and focuses on whether managers stick with their stated strategies to rule out plain luck. They’re also wary of performance skewing due to specific periods, looking at rolling periods to identify consistency. The firm runs “phantom” portfolios to track prospective managers, and, of course, they use a lot more managers in their AA pension fund, so they have a stable of replacements for their mutual funds. Also, they’ve been careful not to let circumstances change their own strategy as well: “Anyone who says they weren’t pressured in 2008 and 2009 has a weak memory,” says Needles. “Everyone was tempted to say ‘this isn’t working.’ But nothing works at the bottom. We haven’t changed the way we manage our managers and have been rewarded by the rebound.”

It’s easy to see why American Beacon is popular with independent RIAs. They use the same multimanager strategy, but possibly to greater effect. It’s why the company has remained loyal to RIAs as well: I suspect independent advisors are more likely to understand American Beacon’s strategies and share its aversion to chasing performance. Hopefully, Needles and his team will continue to resist the lure of high-volume dollars and continue to support its kindred independent spirits.


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