The Education of an Investment Risk Manager, Part V

One thing that came out of our “employee empowerment project” was a need to improve our equity and bond fund offerings.  At the same time, a fund manager manager [FMM] came out of the woodwork and suggested to us that we could do multiple manager funds.  They had analyzed many managers and had found some that they thought were great.

The more we thought about it, the more we thought it would be a great idea. Here’s why:

  • Our own abilities to find superior managers were limited.
  • A few members  of our team (including me) possessed ability to analyze what FMM would bring us.  We thought we could add value.
  • We came up with a clever name, “The All Pro Funds.”
  • We also thought we could add value  in changing weightings every now and then, and firing managers that we felt had become uncompetitive because they were now running too much money, had critical staff losses, or were underperforming style-specific indexes by a wide margin.
  • We could increase our fee a little to pay FMM and us for the additional work entailed.

And whaddaya know?  It worked.  The portfolios in aggregate  outperformed  their indexes even after fees, and fund flows increased dramatically.  The representatives had a story to tell.  Morale improved everywhere.  We were rolling, until…

A day came where we heard from one of the underlying managers that FMM had recommended their termination because they wouldn’t rebate more of their fees back to FMM.  I would not say that we went ballistic when we heard this — instead, we went cold on FMM.  Act fast?  No, act deliberately.  The senior officers tasked me and the #2 guy in marketing to deal with the problem.

We had a rule in our division — we will pay disclosed compensation, or we will pay undisclosed compensation, but we will never pay disclosed and undisclosed compensation.  Why?  We wanted our clients to know that if compensation was disclosed, that’s all there was.  If there is no “sticker price” but you are happy with the services provided, and don’t need to know what any agent is making that’s fin with us.  But we will not pass more money quietly to those that have said, “This is the sticker price.”

FMM had violated our sense of ethics to the core.  The two of us decided to put out an RFP, asking them to bid to help manage the now $1 Billion of assets. We excluded FMM.  We chose 10 well known manager consultants. Most responded to the RFP and we invited 5 to come present to us on a given day in spring.


I need to mention one other thing.  When we first started dealing with FMM, we appreciated their qualitative research, which seemed to have some punch.  After a year, they discovered returns-based style analysis.  This allowed them to analyze many more managers just by looking at their returns, and correlating them to a variety of equity and other indexes.  They stopped the qualitative research.

The first time I saw it, I thought it was hooey, even as I think MPT is hooey.  When you have a lot of highly correlated indexes, any attempt to intuit the style of a given manager is problematic; the error bands get too wide.  It is too difficult to determine what the correct answer is.  The optimal answer mostly represents happenstance, and not fact.  Tiny tweaks to the data produce big changes in the answer.  Not a good system.

There was one incident where I met with their new quantitative analyst, a woman 10 years younger than me.  She ask if we understood how the method worked.  I replied with some mathematical jargon regarding the method, leading her to say, “Oh, so you *really* understand this.”

Also, when I analyze a manager, I like looking at what they own.  I like looking at their trades.  I want to see consistency with what they claim is their strategy.  I also like to hear why they do what they do, and what sustainable competitive advantage they think they have.  There is value in that style of analysis.  There is little value in analyzing returns.


To our surprise, one well-known consultant [call them STAR] that had no for-profit clients was one of the five.  The leader said it was a one-time experiment, so they were evaluating us, as much as we evaluated them.

On the day when they came to present, the presentations were all over the map, from highly professional to “did not prepare.”  Some big names could not answer basic questions about what sustainable competitive advantages they brought to the process, or were fuzzy about how they earned their money.

STAR had the best presentation, services, model, ethics, etc.  It was almost “no competition,” and they liked us as well.  We hired them, much to the chagrin of FMM, who begged us to keep them.  It had the following positive results:

  • Management fees down by 60%
  • Fund manager fees down by 50%
  • Far better marketing cachet
  • Better models for investment analysis.

We reduced client fees, but had better margins, and still greater growth.  Our division was transformed thorough the two projects.  Before we started our ROE was around 8%, and we were growing AUM at a 5-10% rate.  By the time all these changes occurred, our ROE was 25%, and our growth rate was not far from that.  We were now the stars of the firm, even though the firm culturally could not acknowledge that, because the life division was so big.

I learned several things from this five-year escapade:

  • Creating a desirable investment product takes work.  If you do something different that seems to add value, it will attract clients. (“We manage the managers for you, so you don’t have to”)
  • Focus on ethics in those you work with.
  • Reduce fees where possible, both your own, and that of suppliers.
  • Name recognition helps.
  • Be careful what you accept as analysis.  Just because there is clever math does not mean it represents how reality works.
  • If you don’t take chances, you won’t achieve anything great.  We didn’t have to burn our old strategy, and move to multiple manager funds, but we did it, and it made clients a lot happier.  The added work was work that that we liked to do.
  • Even if you have a supplier that did something good for you, do not tolerate breaches in ethics.  Find someone else to help you even if it costs more.  That it cost us less was merely a plus.