Three Eras of Selecting Peers for Contract Renewal - February 2010
Written by Sara Yerkey and Meyrick Payne   

For many years the principle methodology for selecting peers to assess investment performance and fees and expenses has been based on either investment objective or investment style. This MPI Bulletin argues that a supplemental selection process should include investment strategy. The principle logic behind this concept is that to a greater and greater extent the differentiator between alternate funds is based on how investment selection decisions are made rather than the result of those decisions.

We note that there have been three eras of peer selection: (1) investment objective - the original designations which were for many years the preferred basis of fund stratification, (2) investment style - the widely followed stratification process which became the most effective way of describing the capitalization and strategic positioning of investment positions, and now (3) investment strategy - representing process by which positions are acquired.

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There are many reasons why any of the three techniques might be appropriate in a particular contract renewal negotiation, but thus far using investment strategy has not generally been considered.

Two of the most important objectives of the contract renewal process are to (1) evaluate the nature and quality of service provided by the investment advisor - usually measured by comparative investment performance and (2) to assess the overall effectiveness of expense control, including the fairness of the advisory fees and other expenses paid to the advisor.

Typically the peer group used to evaluate investment performance is larger and more inclusive than the peer group of the assessment of expense control. This is because the investor, faced with a particular objective, has a broad set of alternative funds in which to invest. As a result the selection of a peer group to evaluate investment performance can include all the funds in particular objective, style or strategy. Indeed many funds boards use a broad based index to evaluate relative return.

On the other hand, the typical peer selection process used by fund boards to assess expense control produces a narrower selection of peers. This is because the focus of expense control assessment is on the drivers of cost. Many of these are related to the size of the portfolio over which to spread the fixed costs associated with managing an investment portfolio. But they are also very much related to the investment style used to select the positions included in the portfolio. Furthermore much of the law and regulation concerning mutual funds is based upon the fair sharing of the economies of scale and these often differ by strategy.

An example of some of the commonly used equity strategies which fund boards might find useful to compare investment performance and fees and expenses are shown below with a short explanation of why fund operating costs might differ.

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In most cases the investment strategy of a fund is described in the prospectus. As a result it is usually possible to find an appropriate peer group for almost any equity or fixed income fund. Quite often, fund boards have agreed to a list of peers which are regularly used to assess comparative performance.

A few investment houses and independent research providers have assembled lists of funds with similar strategies.  For example, AthenaInvest, Inc. (www.athenainvest.com) in Denver has developed a comprehensive strategy identification methodology for actively managed equity funds which can be used to select a peer group for either investment or expense review.

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With the ever increasing scrutiny of contract renewal decisions by the SEC and even more importantly, the plaintiff's bar, the use of investment strategy to refine the selection of peers for evaluation of investment performance and comparative expenses is an idea worth considering.