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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