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Aspiring Managers (Diverse and Emerging Managers)


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Observations on trends and issues facing emerging managers and minority-, women-, and disabled-owned managers

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Aspiring Managers (Diverse and Emerging Managers)

  1. 1. Knowledge. Experience. Integrity. CALLAN INSTITUTE Research Spotlight June 2016 Aspiring Managers Negotiating the Dual Realities Facing Diverse and Emerging Managers “Callan’s Diversity and Inclusion Policy describes our involvement and support of an inclusive community to ensure continued diversity within the firm. We look for this same commitment to diversity in all of the managers we research.” Ron Peyton, Callan’s Chairman and CEO Ron Peyton is Chairman of Callan’s Emerging and Minority, Women, or Disabled-Owned Managers Committee The past year has featured the acquisitions and closings of several diverse and emerging manager firms, highlighting the variability of possible outcomes that fledgling businesses in this arena face. On one hand, institutional investors are increasing their interest in diverse and emerging managers as they seek diver- sity and new talent for their rosters. On the other hand, these managers contend with mounting client demands, distribution limitations, declining mandates, and an overall downward pressure on active man- agers and management fees. The relentless migration to alternative strategies from traditional stocks and bonds, and the desire by investors to differentiate their portfolios, provides aspiring managers both a challenge and an opportu- nity. How can they take advantage of the shift while reconciling the two realities? What can they do to be positioned for success? Callan has long been on the forefront of these issues, from our founder Ed Callan’s significant role in the founding of Progress Investment Management Company more than 25 years ago to the recent success of our Callan Connects program. Callan’s Published Research Group interviewed two of our experts, Chairman and CEO Ron Peyton and Callan Connects Manager Lauren Mathias, to get their perspective on the diverse and emerging manager arenas.
  2. 2. 2 Callan has an extensive history with diverse and emerging managers. Where did it start? Ron: Our founder, Ed Callan, decided he wanted to get into the manager-of-managers business, so in 1990 he personally provided most of the capital for the launch of Progress Investment Management Company, which was a major event in our industry and a game-changer for emerging and diverse manag- ers. Progress was the first multi-manager asset management organization committed to promoting diver- sity within the institutional investment community. Ed had tremendous foresight and was emphatic that we take a leadership position on this subject. He leaned heavily on Callan Associates to do the research. We created a database of the emerging managers that would be the initial participants in the manager-of-managers fund being sold to institutions. What did Mr. Callan see that others didn’t at the time? Ron: He saw a demand for diverse and emerging managers from public funds, utilities, and consumer-goods companies, but there was no practical way to implement. Trustees sought their inclusion, but were frustrated because most emerging managers were just too small. By combining them into multi-manager portfolios, Progress created a solution to address the scale considerations faced by institutional investors. We recognize that there continues to be a growing imperative within these funds to include diverse and emerging managers. One-third of Callan’s clients are public funds, and they make up approximately half of the assets for which we’re responsible. We also think these managers can bring a lot to the table from an investment perspective. What do you see as their competitive advantage? Ron: Size is an issue with managers. You can’t be nimble if you have a tremendous amount of assets under management. Callan’s President, Greg Allen, published a paper several years ago showing that small cap managers could attribute 75% of their success to their “smallness,” while just 25% was attribut- able to skill. Their agility allowed them to take advantage of opportunities better than their larger peers. We think this may apply to smaller managers in general. The other thing about these managers is that they can be willing to take on more investment risk than estab- lished firms because they are more ambitious to demonstrate their talent. An established firm is not going Offering first or second fund A short product track record of less than 3 years <$2bn–$3bn in AUM, seeking institutional investors Minority, women, or disabled- owned The most commonly used definition A secondary definition Typically applies to alternative firms Requires >50% ownership, may also be referred to as diverse managers Emerging and Diverse Managers Defined
  3. 3. 3Knowledge. Experience. Integrity. to take a lot of business risk because it doesn’t want to lose what it has. There are two sides to this issue, of course. A small firm can get too ambitious and blow up. But if you pay close attention to governance, have smaller mandates, and multiple diverse or emerging firms, you can spread out that business risk. Finally, there’s the entrepreneurial aspect that comes with being an emerging manager. The firm’s leader- ship tends to have more “skin in the game” and is typically closer to the product and its implementation. Lauren: Diversity has become a priority in the investment management industry, not just at an organi- zational level, but also at the firm’s board level. In order to beat the market you have to be different from the market, which means you have to think differently. Diversity gives you a great edge in that respect. Have you seen an increase in the implementation of diverse and emerging manager programs? Ron: We have seen an increase in the public fund arena, and more limited growth on the corporate and foundation sides. We see more implementation within public utilities. They are under a lot of pressure to hire managers that reflect the diversity of their populations. Consumer-goods companies are also more likely to show interest because of their diverse customer bases. Let’s talk implementation. Do more clients use a manager-of-managers program or do they go direct? Lauren: I’d say that about two-thirds of plans invest with diverse and emerging managers through a man- ager-of-managers program. Direct investment is sometimes challenging for large plans because the dollar amount they want to invest tends to be too much for smaller managers to take on. Using a manager-of- managers approach provides a work-around because it allows these plans to allocate large dollar amounts across multiple managers. Also, most large funds don’t have enough dedicated research support to analyze individual manager risk. This is what a manager-of-managers program does—that’s their job. With this structure, fund sponsors have outsourced the research and the due diligence, just like a hedge fund, private equity fund, or a real estate fund (of funds). It makes a lot of sense. Some Callan clients do have direct investments in diverse and emerging managers. We’re able to provide a high level of support in these cases because of our long and involved history in the space. “We are encouraged by searches and hires where the mandates did not specify emerging or diverse managers as a condition. Because we did the necessary research to qualify them, these managers will continue to be able to compete against mainstream firms and prove themselves to investors.” Lauren Mathias, CFA Senior Vice President, Global Manager Research Lauren Mathias oversees the Callan Connects program, which enhances Callan’s coverage of emerging managers and minority, women, and disabled- owned firms.
  4. 4. 4 Callan Connects was founded in 2010 to expand the firm’s universe of emerging managers, as well as firms owned by minorities, women, and disabled people. Lauren, for nearly six years you’ve been holding quarterly sessions in major cities across the country in an effort to get to know as many of these managers as possible. What trends do you see in terms of product offerings? Lauren: This has definitely changed over the years. We’ve now met with around 240 firms. In the beginning we saw mostly managers of long-only U.S. equity strategies. As allocations have changed among larger plans, the diverse and emerging manager spaces have adapted. We observe more strategies in non-U.S. equity with a sprinkling in fixed income. I would say the greatest growth is coming from the alternatives side. We’ve noted a lot more direct hedge funds and real estate funds—even some private equity, as well. To what do you attribute this proliferation of alternative strategies? Ron: Managers have asked themselves, “Where am I going to fit? How am I going to work with large public funds that are decreasing their allocations to public U.S. equity?” I think these managers understand where the market is going. They’re following the cues of their larger peers. Based on what we’re seeing from our clients, public funds are really interested in alternatives and non-U.S. equity. By the Numbers Number of Callan Connects meetings since the program’s inception** 237 Number of distinct investment strategies within Callan’s pro- prietary database managed by firms classified as MWDO Number of all Callan meetings with MWDO firms in 2015* 691 273 Number of Callan clients utilizing MWDO firms52 Number of firms classified as MWDO in Callan’s database130 Assets managed by MWDO firms for Callan clients$21B As of September 30, 2015, unless another date is indicated. *Through October 31, 2015. Includes MWDO meetings through Callan Connects. **Since inception in May 2010 Callan Connects We launched Callan Connects in 2010 to expand our universe of emerging managers and minor- ity, women, and disabled-owned (MWDO) firms. One day each quarter is reserved for meeting with emerging managers with less than $3 billion in assets, as well as MWDO firms with less than $10 billion. We hold meetings in major U.S. cities to minimize travel for firms in or near these locations.
  5. 5. 5Knowledge. Experience. Integrity. How else would you say the diverse and emerging manager universes have changed since 2010? Lauren: Both of these universes have become more concentrated during what has been a really challeng- ing time for active management in general. Whereas mainstream managers have muddled through, a fair number of diverse and emerging managers have gone out of business. A lot of them haven’t been able to win new mandates because they have legacy, long-only U.S. strategies. Anecdotally, I can think of three U.S. equity emerging managers that have gone out of business in the past year. At the same time we’ve observed very little new-firm formation. Is the barrier to entering the market greater now than it was when Callan Connects started in 2010? Ron: I think so—it’s the market. Active management has always been the secret sauce for diverse and emerging managers, and confidence there has waned in the bull market for passive that we’ve been experiencing. Starting a new business is difficult when you’re up against that sort of skepticism. We’re also in an increasingly more regulated world—compli- ance, operations, and technology costs are substantial. In order to be institutionally viable, managers need to find the right outsourced partners or internal systems. There’s been a slowdown in the graduation process of diverse and emerging manag- ers into mainstream investment programs. Why? Lauren: There are two reasons for this: lack of firm formation and asset allocation trends. Think of emerging managers as sitting in a circle within a plan sponsor’s program. In order to leave the circle, they must grow to a size that allows them to graduate into a mainstream role. However, even if they do, the plan sponsor faces the challenge of finding a manager that is “more emerging” to replace them, and there aren’t that many competitive new firms out there. From an asset allocation standpoint, a manager may reach a size where it thinks it’s ready for the main- stream, but if the strategy is long-only U.S. equity—and the plan is already at its maximum allocation— there’s nowhere for the manager to go. For defined benefit plans, the cash flow is negative. More is going out for benefits than is coming in from contributions. Because of these factors, you sometimes end up with a plan that’s static because the drivers that create movement don’t exist. While many plan sponsors lack a clear graduation process, we are seeing more actively addressing the issue. 201520142013201220112010 36 45 47 33 43 33 Annual Callan Connects meetings since program inception Historically, firms have only met with Callan via Callan Connects once, then they initi- ate contact via meetings with our Global Manager Research team. Thus, these numbers generally reflect unique, individual firms that were new to Callan. Beyond Callan Connects To improve emerging and diverse manager hiring in the institutional community, these managers need direct access to consultants, staff, and decision makers to cultivate the nec- essary trust in a relationship. In addi- tion to Callan Connects, Callan has a formal, ongoing meeting policy for our consultants and manager research analysts to ensure they are respon- sive to meeting requests from all man- agers in Callan’s database. Managers can access a guide for working with Callan on our website under Callan Connects to effectively reach our con- sultants and research analysts (see Communicating with Callan).
  6. 6. 6 Ron: It’s not like a firm can go from emerging to mainstream manager—boom—just like that. There’s an adolescence, a middle ground. I hear a lot of these firms complain that they’re too large to be considered emerging, but too small to get the mandates that big, mainstream managers get. What “parenting advice” would you give these firms to help them cope with the adolescent years? Ron: They have to realize that this period exists. The industry will call these firms “emerging” even after they’ve emerged. Also, these managers should be mindful that they cannot afford to take their money out and spend it on things that aren’t necessities. They have to leave it in the firm. The company needs to remain well-capitalized because cash is king for any business. Lauren, through Callan Connects you’ve had the opportunity to see a lot of firms come and go. What advice would you give to a new diverse or emerging firm that would give it the best opportu- nity for success? Lauren: First and foremost I would say that you have to have enough working capital to last at least three years, because that’s the cycle of new business. You have to have the conversations, meet the right peo- ple, and show a track record. You won’t make it if you expect to have money coming in soon after launch. The biggest mistake these managers make is assuming that if they build it, clients will simply come. Second, you need to have a strong alpha proposition in an area of the market in which clients are currently looking to invest. The manager has to be able to state clearly and concisely the anomaly they are seeking to exploit and how they have the expertise to do it. Finally, it helps to have professionals on board who have had a successful track record elsewhere. This builds client (and prospective client) confidence and trust. Ron: I would add that it’s really important to have an institutional mindset from the get-go. That means having the right operations and back office in place. In order to make institutions comfortable, you need to show that you have a support staff that will enable you to run your business prudently. Having the right investment professionals isn’t enough. Ron, over the years you’ve probably developed an instinct for managers that will succeed and those that won’t. What is the one factor that tends to tilt the scales? Ron: In one word: trust. Successful managers antici- pate the consultant’s inherent fear of the unknown, and help to address it. By their nature, consultants are hesitant with firms they don’t know. After all, we’re Researching and Engaging with Diverse and Emerging Managers • Databases (e.g., Callan, eVestment, Altura) offer access to quantitative information • Publications like Emerging Manager Monthly reveal industry updates and trends • Conferences provide opportunities to con- nect. Many are industry-sponsored (e.g., RG&A Consortium, Opal Emerg­ing Man- ager Summit, SEO Alternative Investments Conference) and other events are hosted by fund sponsors (e.g., CalPERS, Texas Teachers). Fund sponsors are also invited to attend Callan Connects events. • Industry associations are excellent resourc- es (e.g., National Association of Securi- ties Professionals, New America Alliance, Association of Asian American Investment Managers). The Robert Toigo Foundation is a source for identifying qualified candi- dates for employment.
  7. 7. 7Knowledge. Experience. Integrity. in the business of removing risk and keeping our clients from experiencing failures and embarrassing headline risk. Unless we have done considerable due diligence to develop trust, we’re not going to be comfortable saying, “Here’s this new manager. Here’s the next big thing.” To help instill trust in their operations and processes, emerging managers can adopt the Asset Manager Code of Professional Conduct, which is a system of ethical principles developed by the CFA Institute that puts client interests first. If managers can demonstrate that they are in alignment with these principles, it calms fears and puts them on a more even playing field with mainstream managers that have well-estab- lished oversight and compliance processes. What manager qualities stand out the most in Callan Connects meetings? Lauren: I’m impressed with managers that have a five-year plan for their business. They have a keen grasp on their structure, critical asset levels, and key triggers for growth. Knowing what the road to success looks like gives a very positive impression. Some firms will skip over vital points in their histories, so I’m really taken by those that are transparent. They know that in order to understand their future, we have to get a grasp of the past and any ownership changes, asset fluctuations, or structural evolutions that have taken place. To stand out, managers should cover more than performance. People and process matter, too. Performance is important, but we want to know how you got there and the structure that makes success repeatable. Needs capital to invest and build track record Needs to see a proven track record before investing Needs fee revenue for sustainability and growth Needs a fee incentive to offset the additional risk Needs guidance and feedback to become institutional Needs to focus their limited resources on managing the plan Needs autonomy and flexibility to execute strategy Needs added control and mechanisms to provide downside protection ManagerNeeds InvestorNeeds Emerging Manager Needs vs. Investor Needs
  8. 8. 8 Lauren, what would you say is the future of Callan Connects? Are you anticipating any changes? Lauren: Our clients are interested in investing with diverse and emerging firms and there is a significant amount of money at play. We’ve found Callan Connects to be a great way to unite those interests. One of the byproducts of meeting with managers from a relatively confined universe is that, at some point, you’ve met most of them. This is especially true with the low level of firm initiation that we described before. Over the last year, we’ve seen a decline in the number of managers at each of our quarterly meetings, which we think is due to low firm initiation, as well as the fact that we’ve already canvassed most of the diverse and emerging manager universe at this point. We’re now going to pivot some of our focus to reengaging with the managers we’ve met in the past and fur- thering our communication with those trying to get out of the “adolescent” years. Some remain on the small side and it may be difficult to visit a Callan office, so we are traveling to them to keep the dialogue going. Ron: I think this is a very positive development. If you’re circling back with these firms after four to six years, it means that they have proven themselves to be viable. The biggest fear consultants have about these firms is whether or not their strategies are sustainable. The fact that we’re meeting with them again would seem to indicate that they have a durable model and maybe it’s time for them to grow. Let’s say you have a crystal ball. Five years from now, what do you see happening in this area? What do you hope will be happening? Lauren: More plans will engage with the concept of diversity. Firms are becoming more thoughtful about who they hire. As that happens, larger plans will be given the opportunity to hire managers that reflect the diversity of their fund beneficiaries. I hope we move into a period where it will be easier for firms to be creative, and for entrepreneurs to realize their dream of having their own investment firm. We’ve had a challenging cycle for active management, but my hope is that going forward things will be more in the active managers’ favor. Ron: We’re not where we need to be, but we are making progress. When I came into this industry 40 years ago, there were hardly any women, which is no longer the status quo. Look at Callan as an example; women now make up half of Callan’s workforce and half of our management committee. We are far from where we should ultimately be, but to me this signals an open- ness to change. I truly hope that the term “diverse manager” becomes a thing of the past. That is a very long-term hope and there are miles to go, but I think obsoles- cence of that term is the end game. We are hoping for an industry in which every manager is diverse. One last thing to remember is that all managers were once emerging managers. Callan’s Diversity Policy Callan’s culture is one of inclusion and mutual respect. We are proud to support a collegial, diverse workplace where people of all backgrounds want to work together and collaborate in an environment of mutual support. Ours is an inclusive business environment and we are committed to ensuring that our firm reflects the diversity of the communities we serve. Our clients benefit from the rich diversity of ideas, experiences, skills and per- spectives each associate brings to our firm.
  9. 9. 9Knowledge. Experience. Integrity. About the Authors Lauren E. Mathias, CFA, is a Senior Vice President and U.S. equity investment consultant in Callan’s Global Manager Research group. Lauren is responsible for research and analysis of U.S. equity invest- ment managers and assists plan sponsor clients with U.S. equity manager searches. In this role, Lauren meets regularly with investment managers to develop an understanding of their strategies, products, investment policies and organizational structures. Lauren also oversees the Callan Connects program, launched in 2010, which enhances Callan’s coverage of emerging managers and minority, women, and disabled-owned firms. Lauren is a member of Callan’s Emerging and Minority, Women, or Disabled- owned Managers Committee and a shareholder of the firm. Lauren joined Callan’s Client Report Services group as an analyst in October 2004. Prior to Callan, she assisted an independent financial planner in preparing financial plans for individual investors. Lauren graduated from California Polytechnic State University, San Luis Obispo in June 2004, Magna Cum Laude with a BS in Business Administration, concentrating in Financial Management and Enter- prise Accounting with a minor in Statistics. She has earned the right to use the Chartered Financial Analyst designation. Ronald D. Peyton is Chairman and Chief Executive Officer for Callan Associates Inc., an employee-owned firm whose mission is: “Collaborating with each client to build tailored and lasting investment solutions.” Ron provides firm-wide oversight by conferring with associates and clients to improve communications, process, and service quality. He regularly meets with senior industry professionals and actively engages in industry and community events to advocate for the institutional investment industry. Ron is Chairman of Callan’s Management Committee and the Emerging and Minority, Women, or Disabled-owned Manag- ers Committee. He is Chairman of Callan’s Board of Directors and a shareholder of the firm. He serves on the Board of the United Way of the Bay Area, for which he is the Development Committee Chair. He also serves as Chairman of CFA Institute Asset Manager Code of Professional Conduct Advi- sory Committee, and is a member of the Strategic Advisory Committee for the CFA Society San Francis- co. Ron serves as “Counselor” for the Indiana University Kelley School of Business Dean’s Council. He is also an advocate for the Vista Center for the Blind and Visually Impaired, which Callan has supported for more than 20 years. Prior to joining Callan in 1974, in addition to other financial responsibilities, Ron worked with Marathon Oil Company’s pension investments while serving as an officer in the U.S. Army Reserve. Ron earned an MBA degree in Finance and a BS degree in Accounting at Indiana University.
  10. 10. 10 Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational pur- poses only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business. If you have any questions or comments, please email About Callan Associates Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative, customized investment solutions that are uniquely backed by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises on more than $2 trillion in total assets, which makes us among the largest independently owned invest- ment consulting firms in the U.S. We use a client-focused consulting model to serve public and private pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms, investment managers, and financial intermediaries. For more information, please visit About the Callan Institute The Callan Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published re- search, surveys, and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the invest- ments industry. © 2016 Callan Associates Inc.
  11. 11. Corporate Headquarters Callan Associates 600 Montgomery Street Suite 800 San Francisco, CA 94111 800.227.3288 415.974.5060 Regional Offices Atlanta 800.522.9782 Chicago 800.999.3536 Denver 855.864.3377 New Jersey 800.274.5878 @CallanAssoc Callan Associates