Investment Selection and Monitoring Process: A Primer

The ongoing monitoring and selection of investment options are part of a plan sponsor’s fiduciary responsibility. There are many key points a plan sponsor should consider beyond cost and performance (which are important) to maintain a quality investment lineup. Before a fund can be seriously considered for usage, it ought to pass basic screens relative to its peers and benchmark. Some important investment metrics are as follows: manager tenure, performance against an appropriate benchmark, performance against peers, risk, risk-adjusted return, and fees. These metrics serve as a solid starting point for fund selection and monitoring, but there are other questions that need to be asked. Has the performance of a fund been the result of a sustainable investment process? Did the portfolio management team adhere to their investment discipline or did they get away from their style or mandate in pursuit of short term gains? It is questions like this that help us get to the heart of how a fund operates and why its returns are what they are.

Many plan sponsors and investment professionals emphasize risk-adjusted returns as measured by the Sharpe Ratio, which measures the amount of return a manager achieves given the amount of risk taken (as measured by standard deviation). Volatility and price fluctuations are the norm for equities and bonds, but volatility is justified with long-term positive returns. It can be acceptable for certain investment strategies to take above-average risk, but that risk needs to be rewarded.

It is also critical to have reasonable expectations of how a fund will perform in various market environments. No fund will outperform in all markets (bull, bear, neutral). Certain plans may have a participant population more willing and able to weather risk, while for others it may make sense to use funds that swim a little closer to shore. One of the biggest challenges in selecting a mutual fund for a plan lineup is determining appropriate expectations for that particular investment strategy. In what kind of markets will the fund perform well? When does it tend to underperform? (They all do at some point.)

Unfortunately, there is no “magic bullet” fund that suits everyone’s needs. By evaluating measures such as alpha (return vs. a benchmark), beta (how closely a fund moves with its benchmark), upside & downside capture ratios, tracking error and other metrics, one can get a reasonable grasp on what to expect from a fund. It’s also important for fund managers to stick to their process and to do what they say they’ll do. In other words, funds that have too much “style drift” can be a bit unpredictable. If a fund is a small cap value fund, they should invest in primarily small cap value stocks in accordance with their investment discipline. A mutual fund’s returns should be generated by its portfolio management team adhering to an investment discipline, not simply chasing momentum or a fad. For example, most recently we have seen growth stocks outperform value stocks. This doesn’t mean that either growth or value stocks are bad. However, some low-quality pockets of growth stocks that have seemingly unsustainable rates of earnings growth, high leverage, and cash burn rates have garnered a lot of interest from investors looking for high-growth opportunities. This means many fund managers that have a focus on more stable businesses with reasonable valuations, be they growth or value, have not kept up with more speculative managers in the near term. However, as this trend shifts, it is likely that the stocks of quality companies will outperform those of more unstable companies. No particular style will outperform for eternity. It’s worth noting that value stocks have slightly outperformed growth stocks in the long run, but there have been periods of time where growth outperforms.

On an ongoing basis, it’s necessary to perform due diligence on a plan lineup to ensure that it continues to adhere to the plan’s investment policy statement and any other client-specific standards or requirements. This cycle is typically repeated on a quarterly or semi-annual basis. Most plans utilize an investment advisor that can conduct the underlying due diligence on investment strategies to stay abreast of their performance, positioning and economic trends. This entails meeting with portfolio managers or other key people from within an investment strategy’s decision-making team. Ongoing due diligence and research are a necessity, even for funds that are performing well. In the end, retirement plans should aim to utilize investment strategies that are disciplined and focused on delivering results in the long run. These are the strategies most compatible with the investment goals of retirement savers.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

Investment products available through Cammack LaRhette Brokerage, Inc.
Investment advisory services available through Cammack LaRhette Advisors, LLC.
Both located at 100 William Street, Suite 215, Wellesley, MA 02481 | p 781-237-2291