The Process of Monitoring Investment Holdings

While this post discusses the investment monitoring process for 401(k) plans, the process illustrated below is the same process that I use to evaluate investment holdings for my individual clients as well as my endowment and foundation clients.

The process outlined below works for mutual funds, separate accounts, annuity sub-accounts, ETFs, and other collective investment vehicles.

One of the key duties of a 401(k) plan sponsor is to institute a regular, documented process to monitor, evaluate, and if needed replace the investment choices offered in the plan. As an investment consultant to a number of plans, I help sponsors establish this process as a part of the plan’s Investment Policy Statement (IPS).

Typically the IPS will contain a set of objective criteria that will serve to let us know if the manager/mutual fund is performing within acceptable ranges. Typical areas of evaluation:

• Trailing relative performance of the fund over the past quarter, 12 months, 3 years, and five years.
• Relative ranking of the fund for risk-adjusted performance based on a measurement such as Alpha or Sharpe Ratio.
• Relative ranking in terms of the fund’s expense ratio.

Relative ranking is critical. Funds should be evaluated against like funds or peers. It would not make any sense to evaluate a Large Growth fund against an Intermediate Bond fund or an International Equity fund.

Most of this information can be gotten from data bases like Morningstar. Additionally I use the Fi360 Toolkit as it provides a Fiduciary Score for each holding based upon 11 data points.

If the fund fails one or more of the criteria above, this will typically trigger a review, but not an automatic decision to replace the fund.

We also evaluate managers/funds on additional criteria that can include:

• A large change (up or down) in the assets under management. This is especially critical for a small or mid cap holding.
• Is the fund sticking to its charter in terms of investment style?
• Organizational changes. Has the manager who compiled the fund’s great track record left? Has the fund company been acquired by another organization or perhaps gone public?

Several years ago I began to notice a drop in the relative performance of a Mid Cap Growth fund that I used extensively in 401(k) plans and throughout my practice. I ultimately recommended to all clients that this fund be terminated due to the continued growth in the size of the fund. The fund company had recently gone public and this fund was apparently a cash cow for the organization. In my opinion, the right move for the fund’s shareholders would have been to close the fund to new dollars, instead the fund company chose to leave the fund open. Ultimately performance suffered, the fund deviated from its original charter of investing in small/mid cap stocks and became a large cap fund.

More recently a Large Value holding went through a period of exceptionally poor performance relative to its peers. While all Large Value funds suffered during the recent market downturn, this fund performed exceptionally poorly. By their own admission, the fund managers made some ill-advised stock picks. Their time-tested methodology of finding value failed them. After extensive evaluation I decided to recommend that this fund be retained, but placed on a watch list. My reasoning was that the management team that compiled the fund’s stellar long term track record was largely intact and that their process was still a sound one. While the underperformance was disturbing, I felt that fund management would learn from what happened and factor this knowledge into their process going forward. The fund as rebounded nicely in 2009, we continue to monitor this holding closely.

The two examples cited are both actively managed funds. Index funds go through the same evaluation process. Though style and stock picking are typically not issues with index funds, managers can change as well as the indexes tracked by the funds. Both occurred over the past couple of years with one of the most well-know index fund families.

A rigorous process to select, monitor, and replace investment holdings is essential. While past performance is no guarantee of what will happen in the future, a process such as the one above provides a disciplined basis to evaluate holdings.