Healthy competition is to be encouraged. Obsession with the opposition is best avoided.
Rockland Trust Company’s top gatekeeper Doug Butler is a big fan of managers working to outperform one another, but he wants them focused on their own fund rather than their rival’s.
‘We had a convertibles search a few years ago where we had three managers come in, and one of the managers used to work for one of the other funds that was in the finals,’ he recalls. ‘There was incredibly bad blood between them. One manager spent 45 minutes trashing the other firm’s process.
‘That, frankly, is where we see managers getting into a lot of trouble. When they know their competition, they can’t help but talk other people’s books. That was the kiss of death.’
It’s one of Butler’s pet peeves. He told the manager that he should speak positively about himself instead of talking trash about other managers. The feedback was not well received.
‘Our research team… thought the manager was going to jump over the desk at me,’ he says.
Hard to beat
That team consists of five analysts, who are led by Butler in his role as director of research for Boston, Massachusetts-based Rockland Trust. The research team collaborates with 10 internal portfolio managers and the firm’s wider investment group to build and monitor an approved list of 125 mutual funds and 25 ETFs. These are then used to populate a range of model portfolios.
Butler says that 90% of client assets are in about 30 or 40 of the funds, and the rest of the list are backup options.
The portfolios sit on the firm’s private client platform and nine retirement plan platforms, which are used by 13 retail advisors and 10 business development professionals on the institutional side respectively, advising on a combined total of $3.5 billion in assets.
Butler’s list has an average annual turnover of between 10% and 15%, with about three or four of the 30 or 40 funds that are used in the models being changed each year. Fund searches are primarily driven by asset allocation goals, which also guide the decision to go active or passive.
‘We’re unique in that there are areas where a lot of people go passive, but where we think active works as long as you avoid some bad managers,’ Butler says. ‘We look and see whether passive is going to be a top-quartile manager half of the time and a top-half manager more than 80% or 85% of the time. If it is, then it’s really hard to beat.’
Using Morningstar Direct as well as other data services, the team runs all of the funds through a quantitative framework to identify those that are worth further investigation.
For passive funds, the team seeks out those with the lowest tracking error and the highest R-squared relative to their respective indices. For active funds, the process is understandably different.
‘We like to be concentrated,’ Butler says. ‘We don’t really want a manager who isn’t a quant manager to own 200 names. You can get plenty of diversification with 35 or 40 names. You should definitely be able to get diversification with 75 names, but if you own 200 names, then you’ve just got a bunch of things that you’re not paying attention to.’
The next step is to have portfolio managers send various documents and information so the team can assess the fund further, drilling down to specific positions. That analysis is then used to form the basis for an interview.
‘We can cut through some of the BS,’ Butler says. ‘The tools have enabled us to have better conversations and more frank and honest discussions with managers about what they’re building and what we’re looking for. Sometimes they’re building something awesome but it’s just not what we’re looking for.’
Plus ça change...
Not every meeting features a portfolio manager ready to jump over the desk to attack Butler or trash a competitor. Some are memorable for all the right reasons.
Butler recalls meeting the portfolio managers of the $1.4 billion Royce Special Equity fund about two and a half years ago. He and his team had spent a lot time studying a buy the manager had made nine months previously and were armed with questions.
‘We asked them to take us through their thought process on that. The PM knew the story behind the call better than our analyst did and that was great to see,’ Butler says.
‘It gave us a lot of confidence that they knew their book top to bottom… They didn’t just know the big names and they didn’t just know the big drivers. They had good explanations not only for when they were going to get in but also for when they were going to get out.’
The meeting resulted in Royce winning a spot on the approved list. The fund went on to do well in its first year there, but it has underperformed this past year as its value bias has been out of favor.
Even so, Butler has not lost faith. ‘We still believe in this asset class with this type of manager,’ he says.
A significant change in performance or positioning can mean that Butler and his team put a fund on watch. This doesn’t mean it is off the list immediately or that money can’t go into it, but simply that Butler and his team need to find out more.
While performance is a focus, Butler doesn’t necessarily cut funds that perform badly. Instead, he takes a closer look at funds that are performing in a way that differs from how they were presented by their manager.
‘We had an emerging markets manager where their whole story was downside protection,’ Butler says. ‘We looked and every time the market had been down more than 5% or 6% over the past three years, this manager had underperformed in 10 of the 11 instances of that.
‘They weren’t delivering performance in the way they said they were going to, and when we got the manager on the phone, they flatly denied it, saying that we weren’t thinking about it the right way.’ This talk, unsurprisingly, did not go down well. The fund was soon terminated.
Quit while you’re ahead
The team is also focused on firing managers who are outperforming. It might sound counterintuitive, but Butler explains why it is a priority.
‘Everybody finds it difficult to fire a manager who is performing really well. They may be delivering great performance but you don’t always think that performance is going to last,’ he says.
‘We’ve spent a lot of time this past year figuring out how far ahead of their performance they are delivering and whether we think that’s likely to repeat over the next few years. If we don’t think it’s likely to repeat, we’ll potentially make the decision to replace that manager. It’s always met with a degree of shock from the manager.’
Around 18 months ago, this work led the team to switch out of a small-cap manager who had just delivered a stellar 12 months of performance, having recovered from two years in the wilderness. ‘We had a meeting with them when they were performing poorly. We were debating firing them, but we decided to give them more time and that time paid off,’ Butler says.
‘They delivered 30% returns the following year and then they came back to us thinking they were doing a victory lap, and we were like, “Sorry, but we’re going to be replacing you.” It worked out great because they underperformed by about 10% the following year.’
It was a difficult conversation, but then Butler has never shied away from those.