Portfolio Construction Insights

Part I: Best Practices for Manager Selection

A consistent, structured manager search could benefit your clients and your practice.

Key Insights

  • In this first of two Portfolio Construction Insights on manager due diligence, we suggest four best practices used by professional gatekeepers for their initial manager search.
  • Key elements of a well-structured manager search include: (1) Define the purpose, (2) identify the selection criteria, (3) screen the universe, and (4) make the final decision.
  • A consistent approach to the manager search process can increase confidence in your selections, help address regulatory considerations, maximize investment outcomes for clients, and free up time to focus on building and managing your practice.

As a financial professional, manager selection is an essential element of your practice, and today’s regulatory environment adds to the importance of a consistent due diligence process. We believe a well-structured, efficient process for manager selection can help address regulatory requirements, maximize investment outcomes, and free-up time to focus on your most valuable asset: your clients.

Key Steps of a Manager Search

Professional gatekeepers typically conduct manager searches through rigorous research, using interviews and robust technology to generate detailed investment theses. However, financial professionals often lack the time and resources to conduct such research. Recognizing the complexity of the due diligence process, we’ve split our observations into two Portfolio Construction Insights. In this first installment, we suggest four best practices used by many professional gatekeepers for their initial manager search. Part II will discuss best practices for documenting manager selections and ongoing monitoring of managers on your buy list.

Step 1: Define the Purpose

In order to structure a search appropriately, it’s important to define the purpose. Is this a replacement for an existing strategy or an addition to the buy list? What role is the strategy meant to fill? If the purpose is manager replacement, are you looking for similar exposures? If it’s an addition to the buy list, what gaps, if any, are there in the existing lineup?

Answering these questions is complicated by the fact that Morningstar categories include multiple substyles. For example, large-cap value equity includes deep value, traditional value, and equity income. These substyles often feature different performance characteristics across a full market cycle, and they typically play different roles in portfolios. For instance, equity income strategies may help limit volatility when markets are stressed, while deep value can suffer significant drawdowns in the same environment. To ensure adequate diversification across a category, you must understand which substyle the search is targeting, and buy lists should include exposure to multiple substyles.

Step 2: Identify the Selection Criteria

Selection criteria vary based on the specific search, particularly between equity and fixed income strategies. In any search, identifying an appropriate benchmark is crucial to understanding and evaluating performance. For example, an equity income strategy may use a dividend-focused index, while a deep value strategy may use a broad-based value index.

For actively managed strategies, performance is clearly one of the most important considerations. However, it’s not simply a matter of outperforming an index or peer group. It’s also crucial to consider risk-adjusted returns, absolute risk metrics, and consistency of the performance pattern. Two critical questions must be answered: Has the strategy performed as expected based on its investment process and substyle? And does the return adequately compensate for the inherent investment risk?

Other considerations include which statistics to use (e.g., Sharpe ratio, standard deviation, etc.) and the periodicity (annualized, rolling time periods, and/or calendar year). In addition to risk/return-related data, most professional gatekeepers also evaluate fundamental criteria such as manager tenure, team turnover, assets under management (AUM), and length of track record, among others.

Step 3: Screen the Universe

The starting point for the screens can vary from an entire Morningstar category to a list of preapproved strategies. If you don’t have access to software that conducts a quantitative screen based on the desired criteria, a manual review of potential strategies may be necessary to narrow the universe. Choosing a few “must have” criteria can help reduce the list to a manageable level before diving into the data. For financial professionals starting with a predefined list, using services such as T. Rowe Price’s Art of Clean UpSM may provide data that can help narrow the universe.

Step 4: Make the Decision

After identifying a list of finalists, quantitative comparisons can bring additional differentiators into focus. These could include return consistency; risk/return metrics; qualifications and tenure of the investment team; assets under management relative to capacity; concentration of holdings, sectors, regions, etc.; and any changes or risks to the investment process, including evidence of style drift.

At this point, professional gatekeepers typically interview the managers. If a manager interview isn’t an option, it may be possible to interview a product specialist. In either case, a standard list of questions can help create consistency and aid comparisons. The same information frequently is available on product web pages or through a quick chat with your dedicated contact. Some areas of inquiry include:

  • Firm
  • People
  • Strategy
  • Philosophy and process
  • Portfolio construction
  • Performance drivers

Ultimately, the final selection should be the investment strategy that best fulfills the purpose and selection criteria set forth at the beginning of the search.

Need help?

Manager research can be a daunting task, but it’s a critical step in the broader due diligence process for manager selection. In Part II of our insights on manager due diligence, we’ll discuss the importance of documenting manager selections and the ongoing monitoring process.

A consistent, structured approach can increase confidence in your selections and help to address key regulatory considerations. Importantly, it could also help to maximize investment outcomes for clients and allow you to focus your energy on building and managing your practice.

If you have questions about your portfolio construction challenges, we can help. Call your representative today to set up a consultation with one of our dedicated portfolio construction specialists.

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Additional Disclosures

©2023 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

Important Information

Sharpe Ratio: An investment measurement that is used to calculate the average return beyond the risk-free rate of volatility per unit.

Standard Deviation: Indicates the volatility of a portfolio’s total returns as measured against its mean performance.

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision. Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of January 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

Investing involves risk including loss of principal. Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

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T. Rowe Price Investment Services, Inc., Distributor. Investment advisory services are provided by T. Rowe Price Associates, Inc. T. Rowe Price Associates, Inc. and T. Rowe Price Investment Services, Inc. are affiliated companies.

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