The universe of active investment managers has grown markedly in recent years. According to the Investment Company Institute, in 2013 there were roughly 9,000 registered mutual funds in the U.S. representing $15 trillion of assets, up from 5,700 funds and $3.5 trillion in 1996.1 A quick look at the domestic equity universe alone reveals that there are almost as many mutual funds as there are common stocks that comprise these mutual funds. As might be expected, the quality of management across the full landscape of managers varies greatly. Just as direct investing is challenging across all asset classes, so too is identifying differentiated managers with whom to partner on behalf of our clients. Therefore, in order to create and sustain a successful investment program for our clients across multiple asset classes, it is necessary to have a deeply-rooted investment philosophy, a rigorous investment process supported by a set of manager selection criteria that flow logically from this philosophy and the right team in place to identify and select our investment partners.
At BBH we are value investors and consider capital preservation to be of primary importance. We believe in bottom-up fundamental research and investing with a long time horizon. Lastly, we require managers who invest on our behalf to possess a sound temperament, to be highly disciplined and to exhibit great patience. Based on these principles, we have established a set of criteria for manager selection that guides us in our search for new investments. The criteria can be boiled down into a set of questions which are the section headers throughout the remainder of this article. Importantly, in addition to a dedicated team of analysts that focus solely on the manager selection process, we also have individuals with extensive direct investment experience who are ultimately responsible for manager selection at BBH. We believe this team is uniquely qualified to build partnerships with managers that meet the following criteria.
Does the manager share our core investment principles and invest with an identifiable edge?
BBH insists that our managers share key elements of our investment philosophy: a value-oriented, bottom-up approach, a focus on capital preservation, a disciplined and patient style of investing and a long time horizon. We believe that over the long term, a value-based framework – with an emphasis on purchasing investments at a discount to their conservatively estimated intrinsic value – is the best way to generate attractive absolute returns.2 While an emphasis on value investing may appear limiting at first glance, it can encompass a wide array of investment strategies, from buying shares in exceptional companies at prices below an estimate of the future discounted cash flows to buying the debt of a bankrupt company. We believe that a common sense approach of buying assets for less than they are worth and having the patience to hold them until they approach their underlying values is likely to both protect and grow capital over the long term.
We believe that fundamental research is the most predictable way to generate attractive, absolute, long-term returns. It is difficult to consistently make accurate predictions on macro issues over a long period of time, and it is even more difficult to assess from the outside whether a manager has a true edge in this type of analysis. It is challenging to know when someone making investment decisions based on macro factors is wrong or early, which makes it difficult for us to “hold an investment with strong hands.” For managers that take a fundamental approach to investing it is possible, given BBH’s own team with direct investment experience, to better assess whether the manager has made a mistake in its analysis of the underlying asset or is just suffering a period in which the market is not working in its favor.
Our managers must also have an unwavering focus on capital preservation. Because permanent losses in parts of a portfolio impact the process of compounding wealth, preserving capital is the first step towards growing it. We view this as the investing version of the Hippocratic Oath: “First, do no harm.” A value-based approach is key to avoiding losses because the margin of safety3 required to make an investment provides protection against unforeseeable events. We look for managers who apply these high standards to every investment they make. While some may think this emphasis on capital preservation is a risk-averse way to invest that will result in lower long-term returns, the opposite has proven true. Most great long-term track records have been created by avoiding mistakes that result in a permanent capital loss and by participating effectively in rising markets, which is why we view a focus on capital preservation as a core criterion for our investment partners.
We believe a long-term perspective is critical to investment success. As referenced previously, we seek value-oriented managers that are trying to buy assets for less than they are worth. Effectively executing any value-oriented strategy requires the patience to wait for the market to appreciate the underlying value of the asset. A long-term focus also leads to better tax-consequences and lower transaction costs for our clients, which can add meaningfully to returns for taxable investors. Managers that place significant weight on short-term results are more likely to “follow the crowd” in an effort to constantly be in sync with the market. We believe that it is very challenging for a manger to effectively execute short-term strategies on a consistent basis.
There are many managers that share our investment principles, but that alone is not enough for us to invest. We are highly selective and only seek out a limited number of investment partners. Therefore, we want to identify those managers whose people, philosophy and process lead to a sustainable edge that we believe is highly likely to produce attractive results over an extended time period. A well thought out investment process is only compelling when executed by individuals who also possess a sound temperament. We appreciate investors who are not overconfident, but who work hard to generate a superior understanding of their investments, and who are realistic about the limitations of their knowledge. If a manager does all these things and has an otherwise sound investment process, we believe there is a high probability that it can possess a real edge, allowing it to accurately assess the long-term impact of new developments on the value of its investments and not be swayed by short-term price volatility. We want our partners to have the conviction to add in times when the short-term price is moving against them. We also look for partners who have the ability to admit to mistakes and who will exit a position at a loss if they determine their investment case is faulty.
A critical part of our research process is making sure a manager understands its edge and avoids diluting it over time. Examples of areas that might create an edge for a manager include a focus on a particular part of the market that it knows and understands better than other investors and a unique sourcing network in the case of a private equity firm. Other managers’ edges may come primarily from having their people, philosophy, process and organization well aligned with their strategy. A manager that can articulate the advantage it has over the competition is less likely to take actions that impair that advantage. Understanding that edge also allows us to better monitor a manager’s behavior to make sure it makes decisions that are in the best interest of its long-term clients.
Are the manager’s process, approach and execution of the strategy relatively straightforward and easy to understand?
Opaque strategies that we cannot easily understand are a nonstarter for us. In the same way that we hold our managers to the standard of having complete knowledge of their own investments, we, too, must be able to completely comprehend how managers are generating their returns. Without this knowledge, we cannot assess the likelihood that a manager will be successful in the future. The manager’s approach must thus be transparent enough that we can accurately gauge whether its past returns were generated in a repeatable way. Ongoing transparency into the portfolio is also a requirement.
An understandable strategy allows us to ensure that there is consistency between the articulated investment process, past and present portfolio holdings and returns. A successful track record alone often allows managers to raise substantial assets from new clients, but we believe it is necessary to dig deeper and determine whether those returns were the result of luck or skill, and therefore whether they are repeatable. The repeatability, consistency and logic of an investment process at each step are critical to the success of any investment strategy. Research shows convincingly that both hiring and firing decisions based on past performance alone is not a successful exercise.4 Therefore, at BBH we never screen for managers based on returns. Instead, we focus on identifying managers that meet our qualitative criteria, and then spend the vast majority of our research time evaluating their historical investment decisions and how those have translated into their returns. This includes reading every letter a manager has ever written to its investors and simultaneously looking at every holding and every buy or sell decision. Because we have individuals with direct investment experience conducting the manager research, we often have insight into the manager’s previous investments and can therefore have thoughtful dialogues to better understand how a manager thinks and how it has reacted to different circumstances in the past. It also allows us to better assess the true depth of research that is conducted at managers’ firms and if it is consistent with their statements. It is only after many of these conversations both in person and on the phone with both the key decision makers and their analysts that we can be knowledgeable enough to partner with a manager. One of the benefits of focusing primarily on qualitative research is that we can at times partner with someone who may not have a long-term track record, but who excels in areas we believe make him or her a good investor. This can be advantageous to our clients, who would not be able to benefit from such decisions if we relied on past returns to drive manager selection.
Are we comfortable becoming long-term partners with the firm considering its ownership structure, incentive models, alignment of interests, people and plans for growth?
Our goal when allocating capital to a manager is to create a long-term partnership in which both parties can enjoy mutual success, and a firm’s ownership structure is a fundamental element of that partnership. We look for opportunities where the investment principals are key decision makers for the business and also have a meaningful ownership stake in the firm. Organizations that are governed by large bureaucracies with priorities that don’t align with their investors do not appeal to us. We prefer firms operated by the investors themselves with a strong reputation and a client/investor-first mentality. We find that investor-owned and operated firms tend to be more performance oriented than asset growth oriented. These types of firms also tend to be more disciplined in new product development, have a better appreciation for the challenges the investment teams face and have a longer-term perspective in regards to business strategy.
Before making an investment, we need to be sure that the people investing on our behalf are incentivized to achieve long-term results, and not merely to raise assets to invest. The incentive structures put in place by a firm matter, and they must properly align the interests of clients, investment team members and owners to encourage a superior investment culture and strong performance over time. Incentive structures in which a firm’s owners, and not its investors, reap a disproportionate share of the gains will not allow the firm to attract and retain top talent over the long run.
A key element in creating alignment of interests is for the principals of the firm to make meaningful co-investments in their funds alongside their investors. When fund performance makes a material difference to managers’ personal finances, it focuses their mind on their investment results, which has clear benefits. Interestingly, the AIMA Journal found just this result in a study of hedge fund performance: managers who invest their own capital in their funds tend to outperform.5
Before allocating capital to a manager we spend significant time getting to know its people, as well as ensuring that it prides itself on having a culture of integrity. We look for curious, passionate individuals willing to learn from their mistakes, collegial and collaborative team environments and consistency of personalities. Employee retention can be a key indicator of the quality of the firm. A firm with a flat organizational structure that encourages dissent, adequately compensates its employees based on long-term value creation and fosters a productive work environment should not suffer from excessive turnover. When we meet with analysts individually and go into depth about their investments, we are looking to see that they have applied the firm’s investment process consistently and with discipline and that they have demonstrated sound judgment throughout. For a manager to be successful it needs all members of the investment team pulling in the same direction.
In that vein, we look for managers who are appropriately focused on investing and who do not have excessive administrative, business or marketing responsibilities. While clearly some level of responsibility in these areas is necessary, a manager committed to generating results for the clients will arrange the affairs of the business in such a way that it can focus first and foremost on investing. One caveat to the above statement is that we insist on partnering with managers who are thoughtful about their client communications. While we do not expect them to want to constantly field phone calls from us, we do expect that they take pride in how they communicate their investment processes and results to clients. A manager’s investor letters are one of the primary ways in which we learn about its strategy, and we attempt to put equal time and effort into reading them as the manager does writing them. We also believe in the importance of access to management. While we view ourselves as an attractive long-term partner who understands the importance of allocating time to investing rather than communicating to clients, we also look to build mutual trust between us, our partners and our clients, which requires periodic communication. We will not invest with managers unless they allow us to speak with a key decision maker both during the initial review process and on an ongoing basis.
In addition to maintaining the focus on investing, with adequate attention given to client communications, investment success also requires that managers appropriately consider growth. While we do not fault managers for wanting to grow their firms, we insist on hiring managers who take a disciplined approach to closing strategies that have reached appropriate capacity and who only develop new strategies that either enhance the firm’s ability to provide excellent results for current clients or don’t interfere with serving current clients. All too often firms that enjoy success grow their businesses to the point where their size negatively impacts future investment returns for clients. Even if they stop accepting new money in a particular strategy, growing by launching too many new products can also dilute the focus of firms to the point that they cannot repeat past success. For firms that have grown their asset bases substantially, we discount early returns that were achieved while the fund was materially smaller.
Because we strive for high absolute returns and make no effort to control risk versus a benchmark, there can be times when the performance of our investments will differ materially from that of the market. BBH endeavors to be a thoughtful and patient investor ourselves, and we demand that our managers exhibit this same patience and thoughtfulness. We also believe it is necessary for a manager to have a client base of like-minded investors. This allows managers to devote as close to 100% of their efforts as possible to producing long-term returns and prevents them from having to shift their focus to managing clients during periods of short-term relative underperformance. Not only do we partner with our managers, but we also indirectly partner with our managers’ existing client base.
Is the estimated after-tax, after-fee return relative to the risk we are taking attractive as compared to our other investment options?
BBH constantly monitors the investment opportunity set of both current and potential managers, and when projecting the likely range of future investment returns a manager might reasonably generate, we focus on the after-tax, after-all-fee return to the client. Because of this, in addition to philosophical reasons, for our taxable clients we naturally steer away from high turnover strategies where the gains are primarily composed of short-term gains or ordinary income. Often managers are compensated on pre-tax returns, and because most investors focus on that headline number, there is an incentive in certain instances to make decisions that may be suboptimal for taxable investors. Over the long term, taxes will have a material impact on the actual wealth creation of a strategy, and therefore we spend a great deal of time trying to understand the nature of the income and gains a manager is likely to generate in the future. That is why certain strategies may only be appropriate for tax-exempt clients.
In addition to low turnover strategies, we also prefer sensibly concentrated strategies, as we believe that they have a better chance to outperform over time. Not only is there a body of research that supports that belief, but intuitively speaking, if a portfolio is too diversified, then it is most likely doomed to index-like returns. Additionally, concentration is often a byproduct of managers investing within their circle of competence and only purchasing securities in which they have the highest conviction. As direct investors we appreciate how hard it is to find good investments. When our managers find them, we want those managers to own them in size, for they are the investments that will provide great downside protection and yet retain the ability to compound at attractive rates. We would much rather have our investors own 10 companies that they know well than 100 with which they only have passing acquaintance. We believe that investing in that manner provides both downside protection and upside potential when paired with other elements of our investment philosophy. Given that concentration is a bedrock component of our strategy, we have developed this view in more depth in a separate article in this issue entitled, “The Benefits of Concentrated Portfolios.”
Understanding the risks entailed in an investment is as important as understanding the possible levels of return. Because we are long-term investors, we have the luxury of viewing risk through the lens of permanent impairment of capital: losing money and not getting it back. We believe this is a competitive advantage for BBH and our clients. This longer-term focus on absolute results, which is a direct result of our loyal client base, allows us to be an attractive partner for managers. Many of the best investment firms have a number of options for raising capital, and demand for their strategies outstrips their capacity. The longer-term nature of our thinking puts us in a better position to get access to these select firms.
While we view risk first and foremost as the likelihood of having a permanent impairment of capital, there are also other risks associated with partnering with managers that we devote substantial time to assessing. Price volatility is often used synonymously with “risk,” however it is not a primary consideration for us and is only a true risk to investors forced to liquidate positions for non-investment reasons. Because we never want to put ourselves in a position where we are forced to sell investments for anything other than the difference between market price and intrinsic value, we take a conservative approach to the use of leverage. While we recognize that leverage can sometimes be appropriate, for example with certain types of real estate investments, we do not invest in strategies that require financial engineering to reach an acceptable level of return. We also focus on the liquidity of our underlying investments. Although it is impossible to come up with a single return premium for liquidity because it varies for each investor, we closely track the lock-ups that funds may impose as well as the illiquidity of the underlying assets we own. In cases where our clients’ capital is locked-up over multiple years, we demand incremental compensation versus similar publicly-traded alternatives. We also view risk in light of the complexity of the process and approach a manager employs, the depth of our partnership and the transparency, access and level of mutual trust we have. All of these elements speak to our insistence on knowing what we own and why we own it. For a manager with whom we feel we have a strong partnership, and whose investment judgment we respect, we naturally have a high degree of confidence in the process by which investments come to be in the portfolio. The longer the period of time over which we have a relationship with a manager, the more certainty we will have as to how it operates, and the less risky that investment becomes for us.
A unique feature of BBH is that we have a stable of directly-invested internal strategies that provide us insight on the tradeoff between risk and return present in many markets at a given time. When we make capital allocation decisions regarding external managers, these investments are compared to the internal options we have for allocating capital, on an after-tax, after-fee basis to the client. We evaluate each manager on its own merits before thinking about how it may fit in the context of an overall portfolio. We won’t hire a manager or invest in an asset class solely for the purposes of diversification. Too often investments that are made purely to diversify a portfolio or lower its volatility end up not working as planned when the diversification element is most needed. Instead, our primary way of managing risk is by ensuring each manager seeks to manage risk on its own at an individual security level. That said, when we do find a manager that meets all our criteria, we will think about our allocation to it in the context of our clients’ overall portfolios, with a particular emphasis on balancing the liquidity of the portfolio and offering a prudent level of diversification across asset classes and risk factors.
We believe that BBH’s approach to investing, including selecting third party investment managers, offers our clients an opportunity to earn attractive absolute returns over a meaningful time horizon while at the same time limiting the risk of permanently impairing capital. Because we believe in active management, it is imperative to have a rigorous framework to assess the value that each investment can provide to our clients’ portfolios. Our framework sets high standards for an investment partner’s approach and process, its alignment of interest with investors, culture of integrity and overall caliber of its investment team. We expect to add value for our clients by rigorously adhering to these standards and ensuring that the firms we partner with are managed first and foremost for the benefit of their investors.