October 2009

Bacon and eggs. Peanut butter and jelly. Grilled salmon and a fine Pinot Noir.

Some things just go together.

As with cuisine, blending complementary management styles can enhance a stock or bond portfolio. That’s the concept behind multi-manager mutual funds, which combine carefully selected asset managers in ways that could make the whole even better than the sum of the parts.

“If you hire top talent and combine them in just the right proportions, it’s possible to build mutual fund portfolios that beat their benchmarks and with less risk,” says Northern Trust Company of Connecticut (formerly Northern Trust Global Advisors, Inc.) Vice President Jessica Hart, co-portfolio manager for the Northern multi-manager mutual funds.

Multi-manager funds differ from traditional mutual funds in at least two important respects.

As their name implies, multi-manager products use more than one investment adviser to make buy and sell decisions. They also use managers that are not employed by the investment firm that is offering the mutual fund.

Hiring top talent
Multi-manager strategies have long been popular among such institutional investors as pension funds, insurance companies, foundations and endowments. Deep-pocketed individuals able to meet high private account minimums also have gravitated towards multi-manager strategies in recent years.

And with good reason.

“Sophisticated investors understand that no single firm, no matter how accomplished, has all the answers or all the top talent,” says Peter Jacobs, Northern Trust’s senior product manager for mutual funds. “Common sense tells you that when the search is broadened to include seasoned money managers worldwide, you can put together a very compelling product.”

Compelling indeed, because the potential alchemy of a multi-manager fund stems from how the investment styles and allocations of the managers complement each other — providing the “secret sauce,” as Jacobs calls it.

“We don’t just throw together three or four managers and call it a multi-manager fund, even if they are the top performers in their asset class,” says Hart. “The selection process is highly nuanced and is the result of many experienced professionals analyzing reams of historical information across a variety of disciplines.”

The raw ingredients
There is no shortage of managerial styles with which to prepare the fund portfolios.

Within the equity universe alone, there are growth and value styles, along with multiple variations on each. Some equity managers use a bottom-up process of picking individual stocks with less emphasis on sectors or broad themes, while others employ a top-down approach that concentrates on cyclical or secular economic trends and favored industries. Some managers prefer high-beta stocks (those that are usually more volatile than the overall market), while others go the low-beta route. Quantitative strategies use computers and various metrics to design portfolios.

“The more investment styles there are to work with the more effective a multi-manager approach can be,” Hart says. “You want strategies that complement each other, that cushion and reinforce moves in a portfolio. But it doesn’t just happen by accident, and the manager combinations aren’t necessarily intuitive.”

Experience counts
Constructing multi-manager funds is nothing new for Northern Trust Company of Connecticut (NTCC). For nearly three decades, NTCC has been cooking up the secret sauce for institutional clients worldwide, and manages $30 billion in manager of manager accounts, as of June 30, 2009.

Figuring what’s good for the pros is good for individual investors as well, NTCC introduced its first three multi-manager mutual funds in 2006. Four more have been added since, including the Northern Multi-Manager High Yield Opportunity Fund, which was launched in September. (You’ll find a profile of the new fund in the Flexibility=Opportunity article.)

“We’re now doing for individual investors what we’ve been doing for institutions since 1979,” says Jacobs. “We have the in-house capability to optimize risk-adjusted performance by blending accomplished outside managers in highly specialized ways. The global resources and processes already were in place. Plus, there’s a growing demand for the product. It makes sense to offer it to our individual clients seeking outside managers as well.”

The process
Northern’s multi-manager mutual funds are constructed and maintained through a vigorous four-step process that emphasizes due diligence and first-hand knowledge of the best money managers from around the world.

To begin, NTCC draws upon its 30 years of experience as an institutional manager of managers to prune the global advisory universe from several thousand candidates to several hundred. This initial “cut” is based upon multiple factors, including relative performance, consistency of returns, volatility, managerial stability and stylistic discipline.

That last point is often overlooked, but it’s vitally important.

“We have to make sure that a manager doesn’t have a history of straying from his or her approach,” says Hart. “Style drift is absolutely unacceptable within our multi-manager framework.”

In other words, if the recipe calls for a teaspoon of vanilla, you want to be sure the cook won’t improvise and add a tablespoon.

“Details matter,” says Hart.

Next, NTCC’s 100-plus person staff further reduces the number of candidates by scrutinizing every aspect of a potential manager’s business, going far beyond just the investment approach. In addition to analyzing the investment process and team, NTCC is highly focused on organizational stability, infrastructure, trading and compliance. Strength in these areas is critical for the investment strategy to be implemented effectively. Buy and sell transactions are examined for compliance and transparency.

But some aspects of managerial competence can’t be measured in the numbers alone. That’s why NTCC also conducts more than 700 face-to-face meetings with managers each year.

“We send our most senior people out into the field to meet with every candidate,” Hart says. “If anything comes up in those meetings that leaves us even the slightest bit uncomfortable, we thank them for their time and move on.”

Blending the talent
The third step — identifying managers whose styles we believe best complement each other and assigning an allocation to each — is the most critical part of a very specialized process.

The Northern Multi-Manager International Equity Fund, for example, uses four outside advisers.

Tradewinds Global Investors manages 30% of fund assets using an absolute value strategy, which focuses on stocks that sell at significant discounts from their peers, regardless of sector or country. Altrinsic Global Advisors is assigned 25% of assets, but employs the so-called relative value style made famous by Benjamin Graham and Warren Buffett. To balance the portfolio, two growth managers are used: William Blair (25% in a “growth at reasonable price” strategy) and UBS Global Asset Management (20% in higher-beta, aggressive-growth stocks).

The precise allocations and style parameters are chosen after back- and stress-testing many years of portfolio data, and are designed to achieve the Fund’s objective of benchmark outperformance with muted volatility.

The absolute value component, for example, is thought to provide downside protection in difficult markets while the relative value allocation often outperforms as the economy is rebounding.

Those diverse value styles are balanced against the conservative and aggressive growth components.

“No single factor determines which managers we hire or how fund assets are allocated between them,” says Hart. “It is really a mosaic of information from multiple sources and disciplines that helps us decide how the pieces are put together.”

Daily monitoring
Even after the managerial ingredients are identified and a fund portfolio is created, the process is not over.

Far from it.

The NTCC team monitors every move made by each manager on a daily basis. Trades that seem inconsistent from a compliance or stylistic standpoint are flagged. Managerial performance is reviewed weekly, and quarterly conference calls are conducted between NTCC and the chosen advisers.

Each year, NTCC fires about 10% to 15% of the roughly 250 managers that it uses for its mutual funds and institutional manager of managers accounts.

“We hold them accountable,” Hart says.

Core exposure
The balanced nature of Northern’s seven multi-manager funds make them appropriate vehicles with which to gain core exposure to the various markets they cover.

Because of their broad diversification, however, multi-manager funds could underperform single-manager offerings when market leadership is narrow and the single-manager fund is focused on that small pocket of strength.

For example, during periods when value stocks are routing their growth counterparts, a single-manager value fund is likely to beat a multi-manager approach that employs the growth and value styles.

Jacobs considers such short-term underperformance a small price to pay if a multi-manager fund achieves its broader objectives of long-term outperformance along with reduced risk.

“At any one time, some part of the market is usually hot, and if you’re concentrated in that one sector, you might post the best returns,” he says. “But over the long haul, we think it makes more sense to take a balanced approach that gives you exposure to all the components of a market. You can think of multi-manager mutual funds as providing all the investment food groups in a single meal.”

Bon appétit!