Some of us leave work behind when we get home. The phone gets switched off, the TV comes on, or maybe the mayhem of family life takes over.
Not so with Matthew Babcock. The director of manager research at Pacific Life is hardwired to do due diligence, even when he’s not in the office.
At work, in the firm’s Newport Beach, California headquarters, this means scouring the investment universe for new managers to add to Pacific Life’s variable annuity and mutual fund platforms.
At home, it means looking for the best deals on anything from household goods to boutique hotels. Babcock wants the most bang for his buck and whether it's return flights or flighty returns he cuts through the fluff to make sure he knows what he’s buying.
‘I think a lot of the time, these managers will try and sell you and they’ll exaggerate or embellish things that they’re talking about, saying that everything is going to be fine and the world is never going into recession,’ he says.
Babcock and his Pacific Life team have come across this situation many times when selecting external portfolio managers for the firm’s $7.2 billion mutual fund platform and $45 billion variable annuity platform.
The two platforms pull from a list of 57 strategies, which are subadvised by 28 different asset managers. Investors using the mutual fund platform can choose from 38 externally managed strategies, while variable annuity clients can select from 49, with some overlap between the two.
Babcock is a skeptic at heart. He believes that honesty on both sides is vital to making his relationships with portfolio managers work.
‘Be honest with yourself, don’t be in denial and things will work out,’ he says. ‘Be honest, question everything and be able to live with the truth – whatever that is. Be a realist.’
When searching for new managers, Babcock and his team officially begin their search with a large database such as Morningstar or eVestment, but he says that realistically, more new ideas come from face-to-face meetings than anything else.
‘We travel to London, where we have four mandates. While we’re there we always try to explore new opportunities,’ he says.
These meetings do not necessarily mean that Babcock and his team will add a specific manager to the platform.
Instead it is a way for them to build up their own proprietary database of the different options out there.
It is also at this early stage in the process that Babcock and his team ask themselves why they are considering a particular manager or searching for a certain strategy.
He says they want to know whether it will be new fund, a replacement for an old one or a niche building block for a larger offering.
Running the numbers
Once these preliminary questions are answered, Babcock begins the fun part of the analysis: quantitative screening.
The team screens for performance on a risk-adjusted basis and uses a proprietary factor regression model to separate the impact of a manager’s style and performance from their execution and value added.
The model was developed by fixed income analyst Dave Linton, who was previously a portfolio manager at Pimco, and Ed Sheng, a quantitative researcher from the firm’s asset allocation team.
The model helps to explain a manager’s execution regardless of whether their style is in or out of favor.
‘We’re looking for managers who have executed above and beyond their style,’ Babcock says.
‘We want to understand how that strategy is grounded and how it will perform during different parts of the market cycle, but we also want to select managers who are executing well.’
Babcock says that the model explains how much true alpha, or net-of-factor alpha, has been added by the manager.
Between 20% and 30% of the managers make it through this process. They are then ranked by net-of-factor alpha.
‘If you’re ranking in the top quartile of this net-of-factor alpha, your probability of ranking in the top quartile again is better than your normal distribution,’ he says.
This initial screen leaves the team with about 10 or 15 candidates, on whom more fundamental work is carried out. Five or six then get a call from Babcock and the team to discuss things further.
These calls may be informal, but managers should watch what they say, or at the very least how they say it.
‘I would tend to be concerned if I felt that someone was overpromising or speaking in hyperbole. I prefer someone who is a little more humble and realistic,’ Babcock says. ‘I tend to question or put up my guard with managers that come across as really sales-y.’
Babcock explains that on an initial call with a manager, he does not want to hear them unrealistically portray the strength of their strategy or management abilities.
However, he concedes that a complete lack of confidence would also be a cause for concern.
‘I like to see a balance of confidence and humility. I want the manager to have a lot of conviction in what they do, but at the same time I want them to have the humility to understand that their portfolio won’t always perform well and there are going to be difficult times,’ Babcock explains.
The real fundamental work follows with onsite visits to the two finalists, with the manager who comes out on top then being recommended to the firm’s board of directors.
‘The awareness that they had of individual stocks and the conviction that they had in the way that they manage the portfolio… I wouldn’t say that they blew me away but I left with a lot of confidence in these individuals, that they were going to take great care of the strategy and that they were going to do the best by our investors,’ Babcock says.
Eyes on the prize
It's not all about meeting new managers. The team discusses its entire existing roster on a quarterly basis and meets those managers at least once every 12 to 18 months.
Babcock says that a period of underperformance is not necessarily a red flag, unless it coincides with an environment that should be favorable to a manager’s style. This might see them added to the watch-list.
‘We want to see a manager perform well when we would expect them to perform well,’ he says.
‘Our concern would be when they are severely underperforming for their style, meaning their execution or structure is poor.’
Funds are added to the watch-list, monitored by the board of directors, if they are in the bottom quartile of their category for 18 to 24 months.
They do not make it out of this limbo zone until Babcock’s team either finds a replacement or there is a turnaround in performance that matches the group’s expectations of when the strategy should perform well.
The factor regression model is used to separate luck from manager skill during this process.
Babcock gives the example of one manager who endured a tricky spell and managed to match expectations when their sector specialisms returned to favor.
‘We have a small-cap manager who we hired in 2014, late in their life cycle, and we looked to see how the sectors that they would normally invest in were performing. We said “you know what, this is just out of favor right now,”’ Babcock says.
That manager normally invested in tech and biotech, but hit a rough patch at the end of 2015 when comments in Washington about drug pricing caused biotech to take a hit.
Babcock explains that this sudden reversal of fortune resulted in poor performance for the manager's strategy, but was not the end of the road for his team.
‘We decided we needed to give this a chance to work in an environment that’s more suited for it. We held on and it’s been a much better growth environment for tech and biotech this year, so they’re having a much better time right now.’
Stand by your man
A lead manager leaving a strategy does not always mean it will be cut or put on the watch-list.
Although Babcock was not at Pacific Life at the time, he has some thoughts to share on why the team decided to keep the Pimco strategy on board despite the departure of its mastermind.
‘With Pimco, we felt that there was enough experience managing that product in [Scott] Mather, [Mark] Kiesel and [Mihir] Worah.
'We felt that it was a process-oriented strategy where all of the positioning comes out of the secular and the cyclical forum that those individuals were a part of.’
‘We knew we were losing a special individual in Bill Gross but we also knew that we had several individuals that were heavily involved with the management of that strategy before he left and would continue to be heavily involved.’
After all, it's hardly a surprise that Babcock would have made sure to stick around for a good deal.