Download Investment Process as Competitive Advantage

MARCH 2006
INDUSTRY TRENDS
Investment Process as Competitive Advantage
True Differentiator Factor Stems From the Institutionalization of Retail Markets
At the core of every asset manager are one or
INDUSTRY
more investment philosophies and processes.
Even though firms are generally very comfortable
articulating these concepts, FRC continues to find
that investment philosophy and process are
infrequently integrated into a firm’s overall effort
to differentiate itself in the highly competitive and crowded
mutual fund marketplace.
Due to the continued institutionalization of the retail
markets and the rapidly declining ability of manufacturers to
influence sales, a firm’s success increasingly will depend upon
its investment philosophy and process being used as a differentiator and source of competitive advantage. While strength
of philosophy and process, along with the resultant fund
performance, will not diminish in importance, in an environment where a product’s effect on a portfolio is as important as
its individual attributes, winners and losers will ultimately be
determined by their ability to clearly articulate these concepts
while integrating them into all facets of the business.
To complement the FRC exploration of these ideas at a
high level in the February 2005 issue of the FRC Monitor, this
article will examine a specific example of the application of
investment philosophy and process at GMO as it relates to
three facets:
• Performance results and evaluation
• Management structure and the decision-making process
• Distribution and marketing strategy
Performance Results & Evaluation
Active management exposes investors to beta, or sensitivity relative to the market, and to alpha, which represents
the value added (or lost) by the manager’s luck or skill
relative to the market. However, most active managers do a
poor job of separating their performance into contributions of
This Month Inside the Monitor
What’s in a Name? . . . . . . . . . . . . . . . . . . . .3
More fund companies executing name
changes.
Canadian Firms Hiring U.S. Sub-Advisors . .4
Demise of foreign-content restrictions
expands opportunity in Canada.
alpha and beta; even fewer do an adequate job of
articulating how this performance ties back to an
investment process.
As outlined in the box on page 2, GMO not only
provides a clear picture of the investment process
for each of its funds, but also does a good job of
tying the resultant performance of each of its strategies back
to its investment process. For example, in addition to
regularly providing performance, risk, and security characteristics for each of its funds, GMO also successfully links these
statistical measures back to the fund’s investment process
through quantitative and qualitative attribution analysis.
As an example, consider the following attribution excerpt
from the fact sheet for the GMO Intrinsic Value Fund:
The strategy's stock selection contributed to relative
returns for the period, with much of the positive performance
coming from picks among Health Care and Retail Store
issues. Some negative performance came from selections
among Technology securities, such as the portfolio's
overweight position in Dell, which trailed the Russell 1000
Value index for the quarter.
Two important issues emerge from this paragraph. First,
GMO has included a qualitative assessment of the fund’s
performance, rather than the common approach of many
firms to simply provide reams of portfolio data.
Second, and likely more important, the attribution analysis
that GMO provides is consistent with the fund’s investment
process. For example, based on the fund’s overall bottom-up
process, GMO has correctly focused the above discussion on
security selection results, rather than on broader macroeconomic trends. Too often, fund firms will provide portfolio
commentary and attribution that slices performance in ways
that are inconsistent with the management process, thereby
potentially leading to an erroneous assessment of the overall
investment process.
TRENDS
Benchmarking the Independent
Broker/Dealers . . . . . . . . . . . . . . . . . . . . . . . .6
Comparison of assets under management,
average account size, and total revenues.
ETF Usage in the Variable Annuity Space . .10
Product offerings are currently slim,
but expected to increase.
Velocity of Redemptions/Exchanges . . . .11
By the Numbers:
Total AUM Diversity at MFS . . . . . . . . . . . . . .7
Index of Companies . . . . . . . . . . . . . . . . . .11
Competitive Intensity in the Fund Industry .8
Smid-Cap Funds Have Niche Following . .12
What concentration of net flows tells us
about industry trends.
Product catching on with sophisticated
advisors and institutional investors.
INDUSTRY TRENDS
Management Structure
Just as performance is simply the residual factor of an
investment process, a firm’s management structure is what
ultimately implements this process. Therefore, successfully
articulating how management structure relates to an
investment process can be a useful differentiator for fund
manufacturers. GMO highlights these relationships within its
fund filings as follows:
• Manager compensation details that promote firm-wide
growth rather than individual fund outperformance
• Fund beneficial-ownership details of senior managers
• Details of policies that mitigate potential conflicts
arising from the management of multiple accounts with
varying fee structures, e.g., sub-advisory and separate
account mandates
Distribution and Marketing
At the core of GMO’s marketing effort is a philosophy that
if you provide information that clients need and want, it
allows staff to focus on selling and servicing rather than
dissemination of data. At GMO, not only are product-related
and market-related commentary publicly available, but the
firm also makes the vast majority of the strategy-specific data
discussed above publicly available.
GMO provides its investment management services primarily to an institutional client base, although the firm does play
in the retail space, to a small degree, through its sub-advisory
relationships with Evergreen, Vanguard, and John Hancock.
While GMO certainly utilizes elements of its investment
process to cultivate wins in the sub-advisory market, the firm
does not usually provide further support for the distribution
and marketing of the sub-advised retail product.
Despite GMO’s institutional market orientation, there are
parallels to be drawn between the firm’s distribution and
marketing plans and the retail fund industry norm. Within
the space that GMO operates, its investment philosophy and
processes are synonymous with the asset management
solutions and service it provides; thus the GMO approach
offers a starting point for adaptation to retail efforts.
Although we have seen a move toward greater availability
of market and strategy information in the retail markets,
many firms have falsely interpreted this as an enhancement
to the sales process rather than the price of admission under
a new model. While firms will not be able to exactly follow
GMO’s approach, due to strict marketing regulations with
regard to retail investors, providing unfettered and
exceedingly accessible data to decision-makers should serve
as the core of an effort to intimately tie philosophy and
process to products being distributed.
The table below offers a summary of how investment
managers can apply to their own retail marketing efforts the
principles of the GMO approach to investment philosophy
and process.
Outlook
As a potential factor of differentiation, all investment
managers have access to their investment philosophy and
processes, and yet few apply it in an integrated and
meaningful manner. Since there is a rapidly expanding
amount of sales controlled by investors and advisors where
investment process is the primary decision-making factor, we
continue to see an opportunity for firms to advance their
position by simply listening to the new demands of the
market.
— Ross Frankenfield, CFA & Sam Campbell
Example of Investment Process at GMO
Overview
The GMO Intrinsic Value Strategy seeks to outperform the
Russell 1000 Value Index by 2% per annum over a complete
market cycle with low risk relative to its benchmark. The
Strategy is a structured portfolio that uses fundamental
investment principles and quantitative applications to
provide broad exposure to the large capitalized value sector
of the U.S. equity market.
Methodology
The investment process for the GMO Intrinsic Value Strategy
begins with a universe represented by the largest 1000
capitalized stocks in the U.S. market. Stocks are compared
and evaluated on a monthly basis using valuation and
momentum disciplines. Weighting of the disciplines is
dynamic. As the opportunity to add value increases, the
weight of the discipline in the portfolio may increase.
Portfolio Construction
The GMO Intrinsic Value Strategy is constructed using a
proprietary technique to control risk. Positions are scaled to
market capitalization, and stocks that are highly ranked by
more than one discipline typically represent larger positions in
the portfolio.The Manager attempts to control risk by adjusting
industry sector weights, market capitalization groups, and style
sectors, including growth, quality, and cyclical exposure.Trades
are executed using a proprietary trading model.
Practical Applications of Investment Philosophy and Process
Facet of Process
GMO Example
Application for Investment Managers
Performance
Detailed attribution/portfolio
characteristics
Star founders with emphasis on
team approach
Open access to information for
prospects with product data
inseparable from process
While the provision of data is important, the data must be
relevant and consistent with stated processes
Whatever the existing structure, articulate how this assists
in the implementation of the investment process
Ensure that it is ultimately the process that is being
purchased, regardless of product wrapper or method
of distribution
Management
Distribution & Marketing
Source: Financial Research Corporation (FRC)
2 FRC MONITOR MARCH 2006