An old saw voiced by equity managers is that it is far easier to select a stock than to decide when to sell it. This truism applies, as well, to mutual funds used as plan options. Given enough time, virtually every actively managed mutual fund will experience periods of underperformance and organizational changes. In this situation, the challenge for the defined contribution plan sponsor is three-fold:
* Identify reliable and relevant indicators to help determine if a fund is capable of meeting the plan's expectations;
* Avoid false indicators that might mislead a plan to terminate a perfectly sound fund that is experiencing a temporary period of below-par performance or style drift; and
* Decide within what time frame a termination decision can prudently and confidently be made.
For almost two decades, I have evaluated money managers and their performance from the dual perspective of a plan sponsor and manager of mutual funds using subadvisers. Making probation and termination decisions related to plan investment advisers is, unequivocally, the most difficult task my organization and I face. Even when it is unclear whether a fund is underperforming on a cyclical or secular basis, fiduciaries, by the nature of their position, are compelled to make one of two simple choices:
* Do we provide talented managers with more time to overcome what one hopes is a temporary problem?
* Or, do we disrupt a plan's existing lineup of options by selecting a replacement that, over time, may fare no better than its predecessor?
Long experience confirms there is no simple, foolproof approach to making this decision. The best a plan sponsor can do is to seek to touch all the bases during the evaluation process. This includes reviewing investment returns, multiple risk measures and style drift, as well as qualitative factors related to the investment process and the fund manager's organization.
The essential dilemma -- and built-in limitation -- of judging investment returns is they offer only a "rear-view" picture, and often do not provide a reliable guide to the future. Although comparing the historical returns of a fund against published indexes or a peer group might be the best guide available to sponsors, in our experience, the usefulness of published indexes for this purpose is problematic. Indexes purport to define the return parameters of various equity and fixed-income styles, but they are, of course, an artificial construct, and might not always move in tandem with the "real-life" experience of style peer groups. Indeed, many well-regarded, actively managed mutual funds do not seek to replicate the return and risk profile of a particular index, and that can complicate direct fund/index comparisons.
Further complicating the picture are recent changes in the Russell and Wilshire indexes reflecting how the two dominant equity styles, value and growth, are defined. Both Frank Russell and Wilshire Associates now use multidimensional screens to discriminate between value and growth.
When making comparisons using these revamped indexes, sponsors today must be especially careful to ensure apples are still being compared to apples. The value or growth approach employed by a fund may no longer correspond as closely to the newest version of an index as it did to the former, or vice versa.
Peer groups generally prove to be more meaningful comparison measures than indexes. Assuming the fund in question is measured against an appropriate peer group, it might be helpful for the sponsor to research how often and for what period of time other funds within the group have underperformed. It is not unusual for higher quartile funds to experience below-par returns on a periodic basis. Indeed, research published by Smith Barney's Consulting Group in 1997 suggests funds enjoying several years of outperformance are far more prone than their peers to suffer underperformance in succeeding years.
As a result, subpar returns, by themselves, can create a "false alarm" if they are not viewed over a sufficient time period, and within the context of group ebbs and flows. The sponsor should determine whether the underperforming mutual fund is simply following the pattern common to the group, or whether its returns fall outside the norm.
MONITORING STYLE DRIFT
Plan sponsors have two major concerns in regard to "drift." One is that plan investment advisers will forsake their stated discipline and migrate across equity styles in order to boost returns on an opportunistic, but hardly consistent, basis. An equal, if not greater, concern is a fund will assume an inappropriate asset allocation exposure. If, for instance, an equity manager starts to buy bonds and build cash; or a domestic, investment-grade fixed-income fund purchases non-dollar paper and high-yield securities, the sponsor's alert systems should start to sound.
Portfolio-based style analysis includes reviewing the overall portfolio characteristics (price-to-earnings, price-to-book, yield, growth rate, etc.) and determining whether each individual holding in the portfolio reflects the manager's style. The most commonly employed analytical tool for style drift, return-based style analysis, does not provide as exhaustive and accurate a picture of style as portfolio-based analysis. However, return-based style analysis can deliver confirmation of whether a manager is remaining within its self-proscribed confines, as long as this data is viewed from the vantage point of an appropriate peer group over an extended period of time. Sponsors also should take the opportunity to review fund portfolios on a quarterlybasis via Securities and Exchange Commission-mandated filings, which provide a rapid snapshot of whether the manager is rigidly adhering to the fund's investment guidelines.
Plan sponsors today have an expansive tool kit with which to measure risk, but there is no set formula for deciding which particular risk measures should be employed against a particular fund.
Accordingly, a sponsor's first step is simply to identify those risk measures that will be most meaningful for that particular plan and its participants. In addition to traditional risk measures like standard deviation and beta, sponsors may opt to view funds through the prism of:
* The Sharpe ratio, a measure of total return per total unit of risk;
* Risk-adjusted alpha, which subtracts expected return based on beta from real return;
* Negative return frequency, which is the percentage of time that a weekly, monthly or annual return is below 0%
* The information ratio, which shows relative return earned per unit of relative risk, compared to a benchmark; and
* The consistency ratio, which expresses the percentage of positive active returns relative to a specified benchmark.
Once again, the standard caveat applies: How a fund fares against any or all of these risk measures must be viewed within the context of its peer group.
Although defined contribution sponsors and their consultants might have numerous quantitative tools at their disposal, a complete fund analysis should include a qualitative review, focusing on the state of the fund manager, and the implementation of the investment process. Qualitative questions related to the money management group itself may include:
* Are all the investment professionals connected with the fund, including research analysts, still in place? Are there any additions?
* Have the duties of the investment professionals changed in any fashion? Have any of these individuals been asked to manage other funds, or to assume operational, administrative or marketing responsibilities?
* Has any event affected the stability of the group? Is senior management still the same? Has ownership of the firm changed in any way?
* Have fund assets grown or shrunk? If they have grown, does the fund still have adequate capacity?
* Is the money management group expanding its product line or moving into new markets? Does this mean it will focus less attention and resources on the fund in question?
* Is there sufficient depth to provide backup to portfolio managers, if they leave the firm?
Similarly, when a fund's performance has stumbled, sponsors and their advisers should revisit the investment process, to ensure it hasn't been altered since the original due diligence was performed:
* Is the investment team making buy-and-sell decisions consistent with the stated process? Can the team demonstrate this?
* How have the recommendations of internal analysts fared in the preceding period? Do the internal analysts have a strong success rate? What value is external research adding, if any?
* What proof can the group show that its trading process is highly efficient? Is alpha being compromised by less-than-optimal execution?
* If recent performance has been disappointing, does the management team have a clear, persuasive understanding of why results fell short of expectations? Can they learn from past disappointments to improve future performance?
While a key function of a defined contribution sponsor is to select quality mutual funds for plan options, as a fiduciary that sponsor also must continually evaluate those funds, and make termination decisions on a timely basis. The "right" answer can prove to be elusive, even with all the quantitative and qualitative tools at a plan's disposal.
At the very least, however, sponsors can carry out their fiduciary responsibilities to plan participants by committing to a comprehensive evaluation and decision-making process and following it in a disciplined, diligent manner.