Process for Terminating Investment Managers Is Important

“The Art and Science of Manager Termination” looks at reasons retirement plan sponsors may want to terminate investment managers and offers investment committees criteria by which they can evaluate the underperformance of investment managers.

There are many sound and valid reasons to terminate and replace an investment manager, once the facts have been properly analyzed and considered, says the paper. These reasons can apply similarly or differently for defined benefit (DB) or defined contribution (DC) plans, says Ronald Klotter, managing director of the Arlington, Virginia-based Strategic Investment Group. These reasons can include:

• Adverse organizational change. An investment manager handing off their investment management duties to more junior staff, high turnover in the research staff, or instability within key management are all elements to consider. “How these organizational changes are dealt with by both DB and DC plans are probably very similar,” Klotter tells PLANADVISER, “with the plan sponsor or investment committee still having a duty to oversee these managers and their performance.”

• Unfavorable market conditions. If a plan sponsor or investment committee believes a future market environment will be inhospitable for a manager’s strategy for an extended period, they may want to consider terminating the manager, even if the strategy is otherwise sound.

• Redundancy or irrelevancy. Manager terminations may be initiated if it becomes apparent that their strategy is no longer needed or able to fulfill its role. This reason is less of a factor with DC plans, says Klotter, since investment options are usually structured to be there for specific reasons, with alternative options being offered to participants, such as passive and active investments.

• Failure to meet return expectations. Every manager must meet return expectations. In determining whether or not to terminate, plan sponsors or investment committees should investigate and answer why a manager did not meet those expectations. It also helps for plan sponsors and investment committees to have clear criteria for return expectations and for monitoring managers, says Klotter. Communications can also be a factor, he says, with DC plans disclosing this information to participants, while DB plans would not be required to do so.

• Fiduciary, ethical or operational risks. In this area, plan sponsors and investment committees need to look at operational risks and whether the manager has a poor control environment. However, if lapses by the manager are found to be due to an underlying ethical problem or a lack of timely action, that may prompt immediate termination. Fiduciary concerns are important, says Klotter, regardless of whether the plan is DB or DC in design.

The paper offers a number of steps plan sponsors and investment committees can use to evaluate underperformance by investment managers. Termination should be decided based on both quantitative and qualitative data. Klotter points out this might be more of an issue for DC plans, which tend to use more of a quantitative, rules-based system to evaluate performance. “Plan sponsors and investment committee members need consider factors beyond just performance,” he says.

While performance measurement tools can be used to examine quantitative factors such as the duration of manager underperformance and the volatility of the investment strategy during different market cycles, the paper recommends that plan sponsors and investment committees also use qualitative tools, such as regular calls and meetings with the investment manager, to make a final decision about termination.

Other steps that can be used for evaluation include:

• Getting the facts and investigating the cause of underperformance. Analyze the manager’s situation on the basis of facts and not ill-defined negative feelings.

• Do a case-by-case analysis. Do not have pre-determined tolerance bands for managers for deviation from the benchmark. Discern what is driving the underperformance and judge if it is likely to persist in the market environment.

• Know the investment managers. Seasoned, senior executives should manage the sourcing, due diligence, hiring and firing decisions, and monitoring of investment managers.

• Factor in shifts in the market environment. When looking at underperformance, remember to take into account that a change in the market environment may change things over an extended period of time.

The paper concludes that plan sponsors and investment committees must regularly revisit their reasons for investment manager terminations to make the most intelligent decisions possible.

A copy of the paper can be found here.