wiley finance, investment manager analysis - a comprehensive guide to portfolio selection, monitoring and optimization [2004 isbn0471478865]

Investment
Manager
Analysis
ffirs 6/4/04 2:05 PM Page i
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ffirs 6/4/04 2:05 PM Page ii
Investment
Manager
Analysis
A Comprehensive Guide to Portfolio
Selection, Monitoring, and Optimization
FRANK J. TRAVERS
John Wiley & Sons, Inc.
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Copyright © 2004 by Frank J. Travers. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
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Library of Congress Cataloging-in-Publication Data:
Travers, Frank J.
Investment manager analysis : a comprehensive guide to portfolio selection,
monitoring, and optimization / Frank J. Travers.
p. cm.—(Wiley finance series)
Includes bibliographic references.
ISBN 0-471-47886-5 (cloth)

1. Investment analysis. 2. Portfolio management. I. Title. II. Series.
HG4529.T735 2004
332.6—dc22 2004005532
Printed in the United States of America.
10987654321
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web at www.copyright.com . Requests to the Publisher for permission should be addressed
For more information about Wiley products, visit our web site at www.wiley.com .
To . . .
. . . my wife and best friend, Tara, who has offered
me encouragement and support not just during the
months it took to write this book, but over the course
of our lives together.
. . . my children, Brendan, Sean, and Lauren, each of
whom inspires me to be a better man than I thought I
could ever be.
. . . my parents, who instilled in me a strong work
ethic and who always told me that I could do anything
that I put my mind to.
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Contents
Introduction ix
PART ONE
Before the Analysis
CHAPTER 1
Setting Investment Guidelines 3
CHAPTER 2
Investment Manager Sourcing 11
CHAPTER 3

Request for Information 31
PART TWO
Equity and Fixed Income Manager Analysis
CHAPTER 4
Performance Analysis 39
CHAPTER 5
Risk Analysis 77
CHAPTER 6
Portfolio Analysis 101
CHAPTER 7
Information Gathering 133
vii
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CHAPTER 8
Initial Interview 155
CHAPTER 9
Attribution Analysis 179
CHAPTER 10
Style Analysis 209
CHAPTER 11
On-Site Meeting 221
CHAPTER 12
Investment Manager Scoring Model 241
CHAPTER 13
Background Checks and Contracts 285
CHAPTER 14
Fixed Income Manager Analysis 301
PART THREE
Alternative Investment Manager Analysis
CHAPTER 15

Hedge Fund Manager Analysis 329
Index 373
viii CONTENTS
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Introduction
A
ccording to statistics collected by Standard & Poor’s and presented in
its annual Money Management Directory, there were just over 13,000
investment advisers managing money in the United States at the end of
2002. Nearly a quarter of those firms managed more than $100 million in
assets. Some are of these investment companies are large, well-known
firms with dozens and sometimes hundreds or even thousands of employ-
ees and with client bases spread out across the globe; others are small one-
or two-person shops that service a more localized clientele. The products
they manage range from publicly traded mutual funds to commingled
trusts to separate accounts designed for individual clients. In addition, the
product mix is quite diverse, covering a myriad of asset classes that differ
across capitalization ranges, geographical boundaries, risk levels, and a
variety of other classifications.
The assets managed by these firms at the end of 2002 totaled an as-
tounding $21.3 trillion, representing more than 75,000 public and private
pension plans—and these statistics do not cover the mutual fund industry.
Given those rather impressive statistics, you would assume that a wide
variety of books and scholarly research papers covering the subject of in-
vestment manager analysis would be available to plan sponsors, investment
consultants, financial advisers, fund-of-funds managers, and individual in-
vestors. While some books currently available are dedicated to or include
chapters on topics such as performance analysis, attribution analysis, and
portfolio analysis, to my knowledge no book has combined all the elements
needed to effectively analyze investment firms, products, and professionals.

Since a large percentage of the investments made in the United States on a
daily basis are made by professional investment managers on behalf of their
clients, I thought a book detailing a methodical process by which people
could evaluate investment managers and the products they manager was
long overdue.
INDUSTRY CHANGES
Over the past 15 years, I have found that the investment industry has
changed considerably. Information that was available only to professional
ix
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investors in the late 1980s (at very high prices) is now available free to all
via dozens if not hundreds of web sites on the Internet.
When I first entered this field in the late 1980s, the primary issue was
how to go about finding the best investment managers for specific searches.
The Internet existed back then, but was scarcely used outside of academia
and the military. In addition, the process of conducting a search for an in-
vestment manager based on investment style, geography, or market capital-
ization was much more manual and time-consuming than it is today.
Lastly, there were no real reporting standards in place back then, so I spent
a great deal of time poring over reams of printed material and then enter-
ing the data into spreadsheet programs that I had designed to dissect the
data and put it back together—all this in an effort to make data from dif-
ferent firms comparable.
The issue today is quite different. It is no longer how to get the infor-
mation; it is what to do with all the information now available. Technol-
ogy has obviously changed this business in many ways. For example, it has
made it possible to conduct complicated statistical studies in a matter of
seconds. Studies that would have taken days (or possibly weeks) just a few
decades ago can now be accomplished with the push of a few buttons. In
addition, advances in computer hardware have given rise to the investment

software industry. As computers got smaller and less expensive and as
processor speeds increased, the types and sophistication levels of analytical
techniques increased right along with those advances.
There are software packages that will perform manager screens for
you or analyze style, performance, or portfolio fundamentals at the touch
of a button. In addition, the advent of the Internet as a source of informa-
tion and communication has been nothing short of monumental. I could
not function as efficiently without the Internet and e-mail capabilities.
However, these advances, while generally positive, can lead to an over-
load of information—in effect prompting many not to see the forest for the
trees. In addition, as we come to rely more and more on computer pro-
grams to perform complex analytical functions, we tend to forget some of
the theory and investment mathematics behind the analytical reports.
However, having access to various analytical reports is one thing; the abil-
ity to understand and interpret the reports is another thing entirely.
Yet for all the changes that have occurred in this industry over the
years, much has stayed the same. While it is true that we now have access
to much more information than we did a decade ago, the most important
element of the process has remained exactly the same: Investment products
are invariably managed by investment professionals (even quantitative
strategies need to be created, monitored, and tweaked by people). Under-
stand the people, and you are more than halfway there. The analytical
process described in this book combines both qualitative and quantitative
x INTRODUCTION
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measures, which effectively combine the art and science of evaluating and
selecting investment products.
THE SEARCH PROCESS
To give a complete picture of the steps that go into a typical search for an
investment manager, this book outlines the process from start to finish.

Step One: Set guidelines.
■ Investment policy statement.
■ Submanager guidelines.
■ Setting responsibilities.
■ Budget issues.
■ Operational issues: time frame, asset size, etc.
Step Two: Source investment managers.
■ Internal/external databases.
■ Media: newspapers, magazines, journals.
■ Internet.
■ Professional contacts.
Step Three: Screen the universe.
■ Setting minimum standards.
■ Risk/return parameters.
■ Fundamental characteristics.
■ Style orientation.
Step Four: Request and organize information.
■ Performance.
■ Portfolio holdings.
■ Professional biographies.
■ Form ADV.
■ Presentation books and firm literature.
Step Five: Analyze managers and products.
■ Initial phone interview.
■ Performance analysis.
■ Style analysis.
■ Risk analysis.
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■ Portfolio analysis.

■ Factor analysis.
■ Face-to-face meeting.
■ Ranking model.
Step Six: Compare finalists.
■ Investment professionals.
■ Process used.
■ Portfolio characteristics.
■ Performance.
■ Portfolio turnover.
■ Fees.
■ Asset allocation.
Step Seven: Select manager(s).
■ Optimization relative to existing managers.
■ Investment committee.
Step Eight: Prepare contract.
■ Investment manager guidelines.
■ Fees and calculations.
Step Nine: Monitor manager(s) hired.
■ Monitoring manager(s) using all tools listed in step five.
■ Transaction analysis.
■ Continuously optimizing each manager versus rest of overall portfolio.
The book was structured to follow this general outline. Also bear in
mind that the search process is actually more circular than linear—the an-
alytical stage leads to the hiring stage, and once a manager is hired we
start back at the analytical stage in order to monitor the manager’s effec-
tiveness. The steps previously listed do not have to be followed in strict
order. When analyzing an investment manager, the steps can be altered
and changed as a result of scheduling, information delays, and a variety of
other factors.
OUTLINE AND STRUCTURE

The structure of this book is designed to take the reader through all the
stages of the investment manager analysis process. Each chapter focuses
xii INTRODUCTION
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on a different aspect of the process or on a different asset class. To better
illustrate each of the formulas and concepts detailed throughout the
book, I created a fictitious investment firm, CAM Asset Management,
and use the data from CAM’s underlying portfolio to illustrate how to
perform each calculation and, more importantly, how to evaluate the re-
sults. Each formula and analytical technique discussed in the book is
broken down and explained in great detail. CAM Asset Management is
a fictitious investment firm that is based on a composite of investment
firms that I have analyzed over the years. The investment team at CAM
is also fictitious.
My ultimate goal in writing this book is to provide a practical, real-life
method of analyzing investment managers—not to create a purely acade-
mic treatise. As a result, the style and tone that I employed when writing
this book straddle the fence between academic and conversational.
Each chapter begins by defining all the relevant issues, concepts, and
formulas. As the chapter progresses, each formula, concept, and analyti-
cal technique is identified and explained in detail. The organization of
the book is also by design. The book’s first part deals with all the prelim-
inary (background) work that needs to be done before we can actually
begin to analyze an investment manager. The second part focuses on
traditional asset classes, such as equity and fixed-income investment
managers. The final part focuses on an alternative investment product:
hedge funds.
Part One
This part discusses the steps that typically precede the actual manager
analysis. Chapter 1 focuses on the identification of investment guidelines

and investment manager objectives. Chapters 2 and 3 outline the methods
currently available to source investment managers and discuss how to
quickly and efficiently obtain enough relevant information to cull the list of
prospective managers down to a smaller, more manageable list.
While not the focus of this book, I consider these chapters to be the
foundation with which any successful investment manager analysis could
be conducted. Setting objectives is a critical element in the overall process
because it provides a frame of reference by which we will be able to make
efficient and effective decisions. It also allows investment manager analysts
to effectively and efficiently manage their time. Naturally, once we set the
objectives, we then need to find an appropriate universe of investment
managers as well as a means of fine-tuning the list. Finally, it is important
to develop an efficient means of collecting data for evaluation. This data
needs to be easily obtained and consistent for all the investment managers
under review.
Introduction xiii
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Part Two
Now that we have formed our objectives and written the specific invest-
ment manager guidelines, the real fun begins. This part focuses exclusively
on the process of analyzing equity and fixed income managers. Because the
process in which we evaluate equity and fixed income managers is similar,
rather than repeating the entire process, I chose to focus on equity in our
case study (CAM Asset Management) in Chapters 4 through 13. At the
end of the part a separate chapter (Chapter 14) discusses fixed income
manager analysis. I elected to highlight equity manager analysis because it
represents the majority of assets held by pension plans, foundations, and
endowments as well as by individual investors. The equity manager analy-
sis section sets the tone for the rest of the book.
Each chapter in Part Two provides further information about the in-

vestment manager across a variety of due diligence topics. I have structured
the chapters to follow the order that I typically use when conducting in-
vestment manager analysis, but the order is not as important as completing
each of the analytical stages before making any decisions.
Part Two takes you through each stage of the analytical process and
provides specific formulas and their real-world applications where appro-
priate. This part focuses primarily on domestic (U.S.) analysis, but to ad-
dress the growing global nature of this business, I have included examples
of international (non-U.S.) equity portfolios when appropriate to highlight
differences in the analytical approach used or to address issues raised when
reviewing non-U.S. portfolios and/or investment companies.
As you read through the chapters in Part Two, you will see how the
evaluation process unfolds. Conclusions based on data in Chapter 5 may
be refuted based on newer information we find later on in the process or by
the results of additional analytical tools employed. Because many of the
conclusions stated in the book are interpretive, you will likely find yourself
agreeing with my conclusions some of the time and disagreeing with them
at other times. This is normal, healthy, and to be expected.
Investment manager analysis is not a pure science. As a result, we all
bring our own unique experiences, prejudices, biases, and opinions to the
table. This book will explain how to analyze a given investment manager;
it will not tell you which one you should hire—that decision needs to be
based on your own specific needs and objectives.
Part Three
This part highlights alternative investment managers—specifically, hedge
funds. Hedge funds are receiving more and more attention from institu-
tional investors with each passing year. As a result, a plethora of new hedge
funds has flooded the marketplace.
xiv INTRODUCTION
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While many of the analytical techniques that we use to evaluate equity
and fixed income managers can also be used to evaluate alternative man-
agers, this part will highlight the unique analytical problems that arise in
these asset classes. For example, information transparency is a realistic is-
sue when attempting to analyze hedge fund managers.
While not exhaustive, Part Three will highlight the issues and offer an
outline to be used when evaluating investment managers in this area.
AUTHOR’S NOTE
I have worked very hard to bring you this book and have spent a great
many hours sitting at my laptop working through the first and many subse-
quent drafts. I have found the process of writing this book to be both re-
warding and frustrating. I have tried to make this book comprehensive,
practical, and relevant to people experienced in this field as well as to new-
comers—not an easy task, I can assure you.
I hope that you find this book helpful, and I would encourage you to
contact me if you have any questions or suggestions related to the book or
any topic related to investment manager analysis. My e-mail address is
In addition, I would encourage readers to
visit my due diligence web site.
Web Site: Due Diligence Network
I created this site to provide cutting-edge research and to discuss advance-
ments in the field of investment manager analysis. It is a not-for-profit site
and is supported by numerous academics and industry professionals. It
contains a variety of papers, articles, and other materials relating to invest-
ment manager analysis across all asset classes, including:
■ Performance analysis
■ Risk analysis
■ Attribution analysis
■ Style analysis
■ Portfolio analysis

■ Interview techniques
Web site name: Due Diligence Network
URL: www.neckerscube.com
E-mail:
Introduction xv
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PART
One
Before the Analysis
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CHAPTER
1
Setting Investment Guidelines
Before jumping headfirst into a pool, first check to see that it is
filled with water.
I
t might sound a bit simplistic, but before we attempt to find and analyze
any investment managers, we should first have a very clear idea of what
we are trying to achieve by hiring the manager. This way we will be able to
put each investment product in its proper perspective. A value manager
can be reviewed in the context of the value style and can be properly com-
pared to a universe of other value managers. Likewise, a short-term do-
mestic fixed-income portfolio can be compared to the appropriate
benchmark and peer group. This practice will save time and make the
process much more efficient.
Investment guidelines come in two primary stages: (1) the investment
policy statement (IPS) and (2) the investment portfolio guidelines. The for-
mer concerns the overall portfolio or fund (such as a pension plan), while

the latter is targeted toward each manager hired to fulfill specific objectives
within the overall portfolio/fund (see Chapter 13). As common sense dic-
tates, all investment guidelines should be well thought out and should cover
every aspect of the investment process, from risk/return expectations to
manager selection to portfolio monitoring. In addition, manager guidelines
should leave nothing open to interpretation. Fiduciaries charged with hir-
ing investment managers as well as the investment managers themselves
should understand the guidelines and willingly agree to them. This avoids
potential headaches down the road.
INVESTMENT POLICY STATEMENT
An investment policy statement sets the framework for all of the investment
decisions that follow. When well written, the IPS helps to ensure that the
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decision-making process with respect to the management of the total port-
folio will be consistent and will serve as a beacon to aid navigation through
unexpected market fluctuations and sometimes tumultuous economic con-
ditions, enabling all parties to concentrate on what they were hired to do
(or what they do best). A well-written investment policy statement typi-
cally addresses, but is not limited to, the following issues:
■ Philosophy or purpose.
■ Return/risk objectives, including thresholds.
■ Time horizon.
■ Type of plan or portfolio.
■ Status of plan funding.
■ Actuarial assumptions, including clearly stated reasoning behind the
return/risk objectives.
■ Cash flow needs or liquidity.
■ Strategy being employed to meet the investment objectives.
■ Permissible investments (financial instruments and asset classes).

■ Restricted investments (instruments and asset classes).
■ Asset allocation ranges.
■ Benchmark(s) for total portfolio.
■ Benchmarks for each individual component of the total portfolio (asset
classes, individual managers, styles, etc.).
■ Plan/portfolio responsibilities (board, investment committee, consul-
tants, etc.).
■ Policies regarding external hires, such as consultants and investment
managers (including language on fees, use of competitive bidding
process, due diligence process, hiring/firing policies, placement of ex-
ternal hires on the watch list).
■ Portfolio and performance evaluations (standards and procedures).
■ Benchmarks and rebalancing policies.
■ Diversification (by manager, portfolio size, geography, investment
characteristics, asset classes, etc.).
■ Portfolio execution and trading strategy.
■ Operational issues (custodial, administrative, spending policy).
However, the investment policy statement should not be written in a
vacuum. Economic and market conditions evolve. As they do, it is impera-
tive that the investment policy statement be reviewed at least yearly on a
strategic level and perhaps more often on a tactical level so that the portfo-
lio has a chance to evolve along with the market.
Many pension plans currently conducting searches for alternative
4 BEFORE THE ANALYSIS
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investment managers, such as hedge funds, only recently changed their
investment policy statements to allow investments in this segment of
the market. These adjustments reflect the ever-changing nature of the in-
vestment industry. Just keep in mind that all change is not necessarily
good. What might be a beneficial change for some might be detrimental

to others.
Because the focus of this book is investment manager analysis (not
overall investment policy), this chapter should serve as a general guide or
outline for the development of a new or the evaluation of an existing in-
vestment policy statement. The remainder of this chapter will highlight
each of the significant sections that good investment policy statements typ-
ically contain.
Investment Objectives
This section is a critical element in the IPS document because it sets the
tone for everything that follows. It is here where the portfolio’s return
and risk expectations are listed. Whenever the investment policy state-
ment is reviewed, the ultimate goal is to ensure that the return and risk
objectives have been achieved. As you can imagine, the objectives should
be realistic and based on long-term assumptions. Many corporate pen-
sion plans got caught up in the bull market of the late 1990s and in-
creased their pension plans’ return expectations far beyond what they
could reasonably expect to achieve. This resulted in faulty pension as-
sumptions that have had a detrimental impact on many companies’ finan-
cial statements and, in the case of some publicly traded companies, the
prices of their underlying stocks.
For pension plans, return and risk objectives may be stated in absolute
terms (example: the portfolio should return a minimum of 8% annually
with a standard deviation no greater than 10% annually) or relative terms
(example: the portfolio should have an annual return in excess of 200 basis
points above the S&P 500 index with a standard deviation no greater than
the S&P 500 index). A basis point represents
1
/
100
th of a percent.

Funds of funds may also state their return and risk objectives in ab-
solute or relative terms. However, because funds of funds are, in effect, in-
dividual investment products themselves, they tend to have a much more
narrow investment focus (example: small-cap, large-cap, etc.). A fund of
funds’ investment policy statement is typically called a “prospectus” or
“offering memorandum.” Because there are legal requirements, investment
policy statements and prospectuses tend to have different formats, but still
contain all of the points listed earlier in this chapter.
Setting Investment Guidelines 5
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Example of Investment Objective
The financial objectives of the plan are based on a comprehensive eval-
uation of the capital markets in the context of modern portfolio theory
and have been measured against the plan’s current and projected finan-
cial needs. Based on this evaluation, the plan will be measured against
a customized benchmark consisting of the following indexes in the
proportions listed:
■ 50% S&P 500 index
■ 10% Russell 2000 index
■ 10% MSCI EAFE index
■ 30% Lehman Aggregate index
The investment objectives for the plan are:
■ To achieve a nominal rate of return for the total portfolio equal to
or greater than the return of the customized benchmark.
■ To achieve a real rate of return in excess of 550 basis points above
inflation, measured by the consumer price index (CPI).
■ To keep the total portfolio’s level of risk, defined as annualized
standard deviation, equal to or less than that of the customized
benchmark.
Responsibilities

Once the objectives have been decided upon, it is important to clearly state
who will be responsible for making sure that all the goals are accom-
plished. This is an important section because it specifies who is responsible
for every aspect of the portfolio’s management. This includes boards,
trustees, internal employees, external investment managers, consultants, le-
gal advisers, and others.
This section offers guidance not only to outsiders looking to establish
contact, but also among co-workers who share portfolio analysis and man-
agement responsibilities. It is basically a detailed organizational chart that
sets the pecking order within an organization.
Asset Allocation
Asset allocation is the subject of entire books, so I will simply state here
that it comes in several levels. First, there is strategic asset allocation. This
form of asset allocation is long-term in nature and is seldom changed or al-
tered. Changes to asset allocation that occur due to short-term shifts in
economic or market conditions are most often referred to as tactical asset
allocation. For a pension plan, the strategic asset allocation decision is
6 BEFORE THE ANALYSIS
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most often arrived at by conducting an asset/liability study, where the
fund’s liability characteristics are considered when developing the fund’s
asset allocation policy.
This typically leads to a list of what asset classes and financial instru-
ments are permitted for purchase. In addition, the list typically states the
minimum and maximum weights according to asset class, market capital-
ization, investment style, and so on. Exhibit 1.1 depicts sample asset allo-
cation guidelines that are broad, while the asset allocation guidelines
depicted in Exhibit 1.2 break the main asset classes down into a variety of
Setting Investment Guidelines 7
EXHIBIT 1.1 Sample of Broad Asset

Allocation Guidelines
Asset Allocation Average %
Equity 50
Fixed income 40
Alternative asset classes 5
Cash and equivalents 5
EXHIBIT 1.2 Sample of Detailed Asset Allocation Guidelines
Asset Allocation Minimum % Average % Maximum %
Traditional Asset Classes 80 90 100
Equity 40 47 60
U.S. 32 35 44
Small-cap 6 7 9
Mid-cap 7 8 10
Large-cap 19 20 25
Non-U.S. 8 12 16
EAFE 6 9 12
Emerging markets 2 3 4
Fixed Income 20 30 40
U.S. 16 25 33
Investment grade 12 20 26
Non–investment grade 4 5 7
Non-U.S. 4 5 7
Developed markets 2 3 4
Emerging markets 2 2 3
Alternative Asset Classes 0 10 20
Hedge Funds 0 5 10
Private Equity 0 5 10
Cash and Equivalents 1 3 5
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subcategories. The more detailed the asset allocation, the more efficient the

overall process will be. For example, it would be easier to perform attribu-
tion analysis when the asset classes have been defined in greater detail.
Also, to create detailed asset allocation guidelines, you need to really think
through the entire process and, ultimately, hold the investment committee
or lead investment professionals responsible for the portfolio’s outperfor-
mance or underperformance.
In addition to breaking out the underlying asset classes further, the de-
tailed asset allocation guidelines set minimum, maximum, and average
weights for each asset class. When setting the guidelines it is critically im-
portant to set asset allocation guidelines that parallel the return/risk para-
meters set in the investment objectives section of the investment policy
statement. For example, it would be nearly impossible to achieve a long-
term return in excess of 8 percent if the asset allocation guidelines empha-
sized short-term fixed income securities and prohibited equity investments
and other asset classes that appear on the higher end of standard
return/risk profile charts. An example of a standard risk/return profile
based on long-term historical performance for various asset classes is de-
picted in Exhibit 1.3.
Short-term bonds appear in the low risk/low return quadrant. In order
to achieve a long-term return of roughly 8%, it would be necessary to in-
vest in some of the asset classes that appear higher up on the risk/return
8 BEFORE THE ANALYSIS
EXHIBIT 1.3 Risk/Return Profiles by Asset Class
Low Return
High Return
Low Risk High Risk
Cash
Short-Term Bonds
Long-Term Bonds
Large Stocks

Small Stocks
Foreign Stocks
Individual Sectors
Emerging Markets
Venture Capital
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