Barclays manager selection0312

THE SCIENCE AND ART OF MANAGER SELECTION
Manager Research at Barclays
WHITE PAPER | March 2012

Wealth and Investment Management
Global Research and Investments


Contents
Introduction ........................................................................................................................ 2
Overview ............................................................................................................................. 3
Why Can a Manager Selection Process Matter? ......................................................... 4
Different Entities Pose Different Challenges ................................................................ 7
Defining What Success Means ....................................................................................... 9
The Art: The Philosophy Guiding Our Investment Manager Selections .............. 10
The Science: Due Diligence in Four Parts .................................................................. 12
Ongoing Monitoring and Review................................................................................. 21
Sell Discipline and Termination Process..................................................................... 22
Conclusion ....................................................................................................................... 23
Glossary and Definitions ............................................................................................... 24

The Science and Art of Manager Selection March 2012 1


Introduction
Dear Clients and Colleagues:

In a single sentence our advice to clients is to:

Design, implement, and maintain a diversified 1 portfolio that is consistent with your
financial situation and your financial personality.

Robert Brown A previous publication in this White Paper series laid out our approach to designing an
Co-Head, Global Research asset allocation and explained why we believe most portfolios should include nine asset
classes in proportions that reflect the investor’s level of risk tolerance and composure.

In this paper we turn our attention to the subject of implementation. Some investors
may choose to invest only in self-selected individual securities: stocks, bonds, futures
contracts, properties, cash instruments, etc. Much more often, however, implementing
some or all of the portfolio will involve directing money to one or more professional
portfolio managers who will, through an index fund, a mutual fund, a partnership, or a
separate account, buy and sell individual securities on the beneficial investors’ behalf. For
some asset classes such as Alternative Trading Strategies, there is no choice; one invests
in a fund or not at all. So whether or not the managers with whom one invests do their
job well goes a long way to determining how one’s portfolio performs over time.

Because we recognize the importance of this aspect of the investment process, here in the
Tom Lee Wealth and Investment Management unit of Barclays we have developed a deeply considered
Co-Head, Global Research and rigorously applied global process for evaluating individual managers. As well, we have
assembled a significant team of experienced, dedicated “due diligence” professionals in our
key offices across the globe. Through our process and our people, we identify the investment
managers who, in our views, are most likely to perform well in the future. The phrase “Past
performance is no guarantee of future results” has become a cliché of disclosure language.
For us it is a core belief.

We want our colleagues and clients to understand the breadth and depth of the process
we go through to identify those select managers we believe warrant inclusion on our
roster of approved managers. So in this White Paper, David Romhilt, one of the global
leaders of this effort, articulates our approach to the science and art of manager analysis,
selection, and “de-selection.”

Sincerely yours,

Robert Brown Tom Lee
Co-Head, Global Research Co-Head, Global Research

1
Diversification does not protect against loss.



Overview
David Romhilt Building the portfolio most likely to achieve your financial goals requires getting two things
+1 212 526 1542 right. First you need to identify the right asset allocation, and, second, you must implement
david.romhilt@barclays.com that asset allocation in the right way. For many investors, implementing an asset allocation
involves hiring professional managers, either through a separate account or a fund, to build
and maintain the various asset class portfolios. However, while most investors are familiar
with the things that make a company’s stock attractive – high earnings growth potential,
cheap valuation, etc. – the process of manager selection is poorly understood.

We all know that because a manager has performed well in the past is not a reason to
believe he or she will do better than others in the future. But what does predict future
performance? Here in the Wealth and Investment Management unit of Barclays, we
regard manager research and selection as both a science and an art. Like science, the
process should be formal, structured and repeatable to create comparative data points
across institutions and asset managers. Like art, the process must be informed by a
philosophy that guides our collective judgment as we integrate our objective findings in a
creative way. The combination of these approaches gives us the confidence to
recommend the managers we have identified to our clients.

Almost inevitably, discussions about manager selection get caught up in the debate
about whether investment managers in general are capable of adding value over an
index 2 over time, but we are not addressing the active management versus indexing
argument here. In fact, we believe there is a place for both investment management
styles in portfolios, and we seek to understand each client’s financial personality to
determine which is the more appropriate investment strategy. 3 For those for whom
active management may be suitable, this paper explains how we go about identifying,
analysing, selecting and monitoring investment management organizations.

2
Manager research is also important for investors who choose to use index funds wherever possible because not
all indexes or index funds are created equal. Some do an excellent job a replicating an index performance, others
much less so. A discussion of this branch of manager research is beyond the scope of this paper.
3
The Wealth and Investment Management division of Barclays has developed a proprietary assessment that
combines insights from the science of behavioral finance and psychology with modern theories of portfolio
management to help us create an Investment Portfolio tailored to each client’s financial personality and objectives.



Why Can a Manager Selection
Process Matter?
Historically there has been a lot of time spent on studying active manager returns versus
indexes to establish whether managers “can” out-perform based on the average manager.
It is not our intention to debate the issue of the average manager (at least not now); we are
not especially interested in investing with an average manager. Our goal is to invest with
some of the best managers in each investment universe, which we would typically define
as top-quartile performance over a market cycle.4

That’s an important definition, one that’s grounded in the empirical evidence. Historically,
top quartile managers within each asset-class peer group have outperformed the
respective index, despite all of the issues cited in past research around survivorship bias
and other issues. That is why it is worth spending time and effort on manager selection.
Figure 1 displays mutual fund “excess returns” (i.e., netted against the relevant index) by
peer group across a number of common asset classes over the 10 years ending 2010.

4
Barclays does not guarantee favorable investment outcomes. Nor does it provide any guarantee against
investment losses.

Figure 1: Net Excess Returns (%) of Top Quartile Mutual Fund Managers by Investment Style
Trailing Excess
Calendar Year Excess Returns
Returns

Rank 5 Year 10 Year 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 Average
5th Percentile 2.7 2.1 3.5 13.6 8.7 14.2 4.6 6.8 4.5 6.4 8.9 15.2 8.6
US Equity
25th Percentile 0.5 0.1 -0.4 4.1 3.0 6.6 0.7 1.8 0.8 0.3 2.7 4.6 2.4
All Large Cap Funds
Median -0.6 -0.8 -2.4 -0.4 -0.3 1.2 -2.4 -0.7 -1.7 -2.5 -1.9 -0.6 -1.2
# of Mutual
- 1,830 1,103 2,420 2,432 2,522 2,479 2,491 2,414 2,215 2,015 1,745 1,508 2,224
Funds (Net)
5th Percentile 3.4 1.8 5.5 15.9 14.4 18.6 4.9 3.9 2.6 13.3 9.1 23.4 11.1
US Equity
25th Percentile 1.0 0.2 1.3 1.9 5.4 10.3 -0.3 0.1 -1.4 -0.2 1.8 8.5 2.7
All Mid Cap Funds
Median -0.3 -1.1 -0.9 -3.1 0.1 3.9 -3.6 -2.0 -4.3 -4.1 -6.2 -1.9 -2.2
# of Mutual
- 717 408 978 1,008 1,126 1,073 1,052 956 852 776 669 537 903
Funds (Net)
5th Percentile 4.4 3.5 6.8 24.3 8.3 18.9 3.0 9.1 6.0 12.1 18.1 20.8 12.7
US Equity
25th Percentile 1.9 1.3 1.9 9.3 1.1 9.0 -1.4 4.1 2.1 1.2 7.9 8.8 4.4
All Small Cap Funds
Median 0.2 0.1 -0.7 3.0 -5.8 2.7 -4.5 1.6 -1.7 -3.5 1.2 -0.7 -0.8
# of Mutual
- 1,128 655 1,525 1,587 1,730 1,683 1,572 1,479 1,304 1,170 1,009 871 1,393
Funds (Net)
5th Percentile 2.7 2.0 5.7 7.1 8.4 9.1 5.2 5.2 3.4 5.2 9.9 12.0 7.1
International Equity All
25th Percentile 0.5 0.4 2.2 0.9 2.7 2.8 1.3 1.3 -0.4 -0.2 2.2 4.5 1.7
Large Cap Funds
Median -1.0 -1.0 -0.4 -3.6 -0.3 -0.8 -0.3 -1.0 -2.6 -4.4 -1.4 0.5 -1.4
# of Mutual
- 500 309 755 747 690 651 583 544 517 470 418 351 573
Funds (Net)
Note: All the time periods longer than one year are annualized. Excess return measures the return, net of the respective mutual fund’s management fees and expense
ratios, relative to an index. The number of mutual funds in the study period is shown net of those who have dropped out or gone out of business.
Source: Investworks.com
4



There are a number of conclusions to draw from the data:

Over the past 10 years, the 5th and 25th percentile managers in each asset class have
outperformed (i.e., had a positive excess return) on a net of fees basis over long-term
periods and in each calendar year.

The degree of excess return diminishes over longer time periods, reflecting that
individual managers may have generated substantial near-term outperformance, but
there is often reversion to the mean over time.

The average (or “median”) manager’s performance, even without taking into
account managers who may have dropped out of the peer group (or gone out of
business) is often at the index or slightly below the index.

The compounding effect of these excess returns can have a meaningful impact on a
client’s wealth over time. Consider Figure 2, in which we map the nominal growth of
$1,000,000 over 20 years assuming an annual return of 6% and assuming varying levels of
excess return. The outperformance over time results in significantly more value.

Figure 2: Growth of $1,000,000 Based on Various Return Assumptions
$MM
8.0
$6.73
-1% Excess Return 6% Return
6.0
2% Excess Return 4% Excess Return
$4.66

4.0
$3.21

2.0 $2.65

0.0
0 2 4 6 8 10 12 14 16 18 20
Years
Returns are annualized and are illustrative only. Source: Wealth and Investment Management

Over 10 and 20 years the power of compounding at a higher rate is substantial, with more
than a $3.5m difference in the end value based on a 10% return versus a 6% return on an
initial $1m investment. Obviously this difference can work in both directions, as poor
manager selection leading to a lower annual return would have the opposite impact.

Past Performance Is No Guarantee…
If one does buy into the premise that there are managers who exist who can out-
perform on a long-term basis, and that this can be meaningful to the value of an overall
portfolio, then can you just invest in managers who have done very well for long-term
periods and expect the performance to repeat itself? This paper answers that question
on many levels, but an illustration of actual manager returns can help explain why it is
not as simple as relying on a manager’s past performance.

In Figures 3 and 4, we show data from the U.S. Large Cap and U.S. Small Cap manager
peer groups published by Investworks that can be used to answer the question: do top
quartile managers tend to stay there? The data represents all mutual funds still in



existence at the end of 2010 that had at least 10 years of actual past returns. The
calendar year data was then grouped into pairs of contiguous 3-year and 5-year returns.
For the first time period in each pair, managers were grouped into quartiles; the
performance of the top quartile managers was then analyzed in the second time period.
Based on this data, it’s clear that top quartile managers do not tend to stay there.

Figure 3: U.S. Large Cap Top Quartile Managers’ Subsequent Performance
Investworks U.S. Large Cap All Mutual Fund Peer Group
Top Quartile Performance Subsequent 3 Year Quartile Rank (Total Universe = 1046)
3 Year Ending Period Ending Period 1st 2nd 3rd 4th
2003 2006 54.8% 23.8% 14.6% 6.9%
2004 2007 27.6% 24.1% 25.3% 23.0%
2005 2008 22.6% 19.9% 31.0% 26.4%
2006 2009 10.3% 9.6% 35.2% 44.8%
2007 2010 24.5% 22.6% 27.2% 25.7%
Average 28.0% 20.0% 26.7% 25.4%
Top Quartile Subsequent 5 Year Quartile Rank (Total Universe = 1046)
2005 2010 16.9% 20.7% 33.3% 29.1%
Note: All the time periods longer than one year are annualized. Excess return measures the return, net of the
respective mutual fund’s management fees and expense ratios, relative to an index. The number of mutual funds in
the study period is shown net of those who have dropped out or gone out of business. Source: Investworks.com

Figure 4: U.S. Small Cap Top Quartile Managers’ Subsequent Performance
Investworks U.S. Small Cap All Mutual Fund Peer Group
2003 2006 42.4% 29.1% 18.4% 10.1%
2004 2007 20.3% 10.1% 20.3% 49.4%
2005 2008 19.6% 20.3% 19.6% 40.5%
2006 2009 32.9% 25.3% 20.9% 20.9%
2007 2010 21.5% 23.4% 23.4% 31.6%
Average 27.3% 21.6% 20.5% 30.5%
2005 2010 22.2% 27.8% 22.2% 27.8%
Note: All the time periods longer than one year are annualized. Excess return measures the return, net of the
respective mutual fund’s management fees and expense ratios, relative to an index. The number of mutual funds in
the study period is shown net of those who have dropped out or gone out of business. Source: Investworks.com

Consider the “Average” data for the three-year periods for both Large Cap and Small Cap
mutual funds; on average, only about 28% of top quartile managers in one 3-year period
then remained in the top quartile in the subsequent period. The data was even worse for
the 5-year periods, where 22% and 17% of the top-quartile managers stayed there. In
other words, as you have read over and over again, past performance is no guarantee of
future results. (While this data focuses on long-only U.S. stock mutual funds, the
conclusion holds true for non-U.S. equity funds as well. The conclusion is less true for
hedge funds and not applicable to Private Equity.)

Despite data like that in Figures 3 and 4, performance continues to be the most
important aspect of most investors’ decision whether to invest with a manager or not.
And that is the biggest reason why most investors fail at manager selection. This paper
details a different approach to the manager selection process.



Different Entities Pose
Different Challenges
Investment management firms and investment products come together in many
different forms, each posing different challenges to a manager selection team. Despite
their wide variety, the firms and products can be segmented into three categories:

Traditional or long-only funds or separately managed accounts (SMAs)

Hedge funds

Private equity or private real estate funds

These groups differ in terms of how they should be analyzed, the amount of information
available, and the business terms they provide investors (see Figure 5).

Figure 5: Investment Manager Classifications
Characteristic Traditional (Long-Only) Hedge Funds Private Assets

Ownership Varies General Partnership General Partnership
Regulatory Oversight SEC None* None*
Transparency Very High Mixed, Low High

Publicly Available Info
Public/Private Databases Private Databases Private Databases
on Managers?

Publicly Available Info on
Yes Yes No
Underlying Investments?
Management Fee +
Management Fee +
Fees Management Fee Only Incentive above
Incentive
Preferred Return
Varies, None, 7-12 Year
Liquidity Terms Generally Daily
Quarterly/Annually Time Period

# of Products 25,000+ 5,000 - 8,000 2,500

Sep Acct,
Investment Entities Limited Partnership Limited Partnership
Mutual Fund, LP

* There is a pending deadline for hedge funds and private equity firms of a certain size in assets to register with
the SEC. Source: Wealth and Investment Management

Traditional investment management is the “easiest” group to research. There is a wealth
of information available – through numerous public and private-subscription databases
and other sources – about managers and the components of their portfolios, which are
made up of marketable public securities. The challenge is navigating all this information
and organizing it in a reasonable manner, as well as ferreting out firms or information
that is not be readily available to the average investor.

Hedge funds are harder to study due to the lack of publicly available information.
Although a number of private-subscription databases provide good – not great –
information on hedge fund managers, they do not cover the entire investment universe.
Also, hedge fund managers understandably tend to be secretive about their underlying
portfolios, especially with respect to their short sales, which makes validating the



investment process more difficult. The combination of limited public information and less
transparency requires manager-research analysts to conduct more manager on-site
visits with hedge funds and to assemble more of the needed information themselves.

Finally, publicly available information is rarest for firms that make private investments
(generally private equity or real estate). Although subscription-only databases exist, they
lack the breadth of data that’s available in comparable databases for traditional and
hedge fund investments. Further, because the investments in individual private equity
funds are drawn down irregularly over long periods of time, and returns are paid out
irregularly as well, it is very hard to compare return data among private managers. While
managers making private investments tend to be fully transparent with what they own,
the lack of publicly available data on the underlying investments themselves makes
analysis or comparisons of the portfolio difficult.



Defining What Success Means
Any investment process should be held accountable for the results it provides investors,
and we believe it is important to articulate how we define “success.”

In situations in which a low-cost index alternative is available, we seek to add alpha, or
risk-adjusted excess returns, of greater than 2% annually to readily available indexes
over a market cycle. This definition of success applies to traditional management where
there is an ability to invest easily and cost-effectively in the beta (the overall market
movement) of a given asset class.

With hedge fund and private asset manager selection, where no simple index
alternatives are available, our definition of success refers to:

An absolute return target: returns should be positive over the life of the investment
or over a market cycle,

The return should be greater than that of the closest liquid substitute available in the
public markets; for example a merger arbitrage hedge fund manager should do
better in terms of risk-adjusted returns than a mutual fund that specializes in
merger-related special situations, and

Peer group performance: we seek to generate excess returns relative to published
peer groups of other hedge fund or private equity managers who are investing in a
similar manner and time period.

Having a defined measure of success allows us to judge ourselves objectively and
creates accountability within the research process.



The Art: The Philosophy Guiding
Our Investment Manager
Selections
Investment management is unique in that success in this business is harder and harder
to replicate going forward – hence the industry’s well-known disclaimer, “past
performance is no guarantee of future results.” Why? Success generally leads to more
assets under management, and as assets under management grow, the portfolio has
reduced liquidity and flexibility because it owns a greater proportion of an underlying
security’s float. Also, as size precludes taking positions in smaller or less liquid issues, the
opportunity set of investments is diminished. Thus, substantive changes in the asset
base over time relative to the capacity of the asset class can make a manager’s past
track record less meaningful.

When we analyze a manager’s performance potential we aim to balance the potential
disadvantages of increasing size against the advantages of dealing with large
organizations, such as greater operational efficiency, more rigorous, formal risk controls,
longer track-record, and so on.

To analyze the impact of asset growth and size, we apply two key criteria to the
organizations we evaluate. First, we believe that independent organizations that are majority
employee-owned do a better job of managing asset size. These organizations tend to have a
direct ownership stake in their business, more of their own money invested in their actual
products and fewer points of distribution to various channels. We believe this ownership
structure creates a stronger incentive to keep the asset size from getting too large.

Second, prior to making an investment we seek to understand where an investment
manager falls in its lifecycle. We believe the lifecycle of a manager generally follows that
of a product or business (see Figure 6).

When evaluating firms earlier in their lifecycle, we can be confident our incentives are
properly aligned and that portfolio managers can be nimble in markets and won’t be
distracted by too many managerial tasks. At the same time we have to subject the
firm’s operations, risk controls and compliance safeguards to particular scrutiny. When
evaluating larger, more mature organizations we need to pay close attention to how
they avoid the inflexibility and distractions that can come with large volumes of assets
under management.



Figure 6: Illustrating a Manager Lifecycle
Firm Assets ($b) Relative Performance
35.0 Startup Phase Growth Phase Maturity Phase Decline 70
30.0 Focus of Our 60
25.0 Manager Research 50
20.0 40
15.0 30
10.0 20
5.0 10
0.0 0
-5.0 -10
-10.0 -20
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Firm Assets ($) Relative Performance

Startup Phase Growth Phase Maturity Phase Decline
Limited capital, seed capital, Success in performance or Success in flagship or Asset growth beyond
friends and family marketing multiple products capacity
Limited product offering Build-out of non-investment At or approaching capacity Lack of generational transfer
Infrastructure not solidified aspects Operations well-built out, of investment talent or equity
Investment process well- Complementary products hiring tends to be non- Investment team departures
defined investment More significant product
Key person and concentrated Succession Planning lineups
investment talent Strategic partnerships /
ownership changes
Source: Investworks.com, Wealth and Investment Management

It is tempting to limit a manager search to the largest organizations. In fact the majority
of managers are hired when they are mature, if not in decline. It’s far easier to perform
due diligence on mature organizations staffed by sophisticated marketing teams than it
is to conduct research on startup or growth firms, where there are fewer quantitative
measures to judge: track records are, by their nature, short and performance reporting
may not be as sophisticated as that of larger organizations. Our approach, therefore,
emphasizes qualitative aspects of due diligence, which allows us to identify organizations
that will have longer lifecycles in our client portfolios, either because they are relatively
small and have room to grow or because they have shown that they can overcome the
disadvantages of size.



The Science:
Due Diligence in Four Parts
Our manager due diligence process can be divided into four categories, each of which
carries equal weight in our evaluation:

Organization attributes

Investment process review

Analysis of historical track record and statistics

Operational due diligence

With organizational attributes and operational due diligence, we have established
standards of how an external investment management firm should be structured and
operate, and our due diligence evaluates how well a given organization meets them.
Should some aspect of a firm’s organization or operations deviate from our standards,
we look to see if there are any mitigating factors that may reduce the associated risk.

With investment processes or historical performance statistics, by contrast, we don’t
have a predetermined set of standards. Evaluating the investment process is the most
time-intensive and difficult component. Different firms with entirely different structures
and track records can be very good investors, and it is important to remain as open as
possible to reviewing each entity independently. The critical aspect is that we view the
track record a firm has produced as a validation of the quality of an organization and its
operations and investment process, not an indicator of a “best-in-breed” manager.

Organizational attributes
The purpose of organizational research is to understand how an investment manager is
formed as a business and investment entity. The aim is to gauge the continuity of the
firm and whether or not non-investment factors could possibly impact its process and
ability to replicate its past performance or success.

At Barclays, we believe that the organizational structure should encourage – not
hinder – continuity in the firm’s investment process. In general, we favor firms with
substantial, broadly distributed ownership among employees, offering focused product
lineups in portfolios of appropriate size for their markets. We discuss these aspects in
greater detail below.

Ownership structure: We look at a firm’s current and historical ownership structure.
Firms can be 100% employee-owned or majority employee-owned; they can be public
companies or have parent ownership by a financial or strategic owner or an insurance
company. All else held equal, we prefer firms where employee ownership is substantial
and broadly distributed because we think this structure limits turnover of key investment
professionals better than does any other and supports a long-term strategic perspective
on the business. Employee-owned firms tend to be less sensitive to asset growth issues
and better at managing their capacity, whereas all of the other structures tend to create
risks to the business that could impact performance in the future. When examining a



firm owned by a parent or “financial conglomerate” we seek assurances that these
companies will be able to retain key employees. These firms also tend to be larger by
nature to justify their scale of operations, and may be less capable of properly managing
capacity. We particularly scrutinize publicly owned firms, especially the larger ones.
Public firms answer to two sets of clients: investors and shareholders. The interests of
these two can be at odds, as shareholders look for asset growth, which can be a
deterrent to future returns that investors seek. This conflict of interest may make the
decision to close a product more difficult at public firms.

Employee compensation structure: We review each firm’s compensation practices for
its key investment professionals and analysts, preferring firms that compensate key
investment professionals in a manner that is competitive and in-line with our long-term
performance goals and expectations. Many firms have adopted compensation schemes
based on rolling multi-year performance that is in-line with their investment time
horizon, and we believe this is the most appropriate method of bonus compensation. It is
also critical that key investment professionals continue to be tied to the firm in terms of
equity ownership and/or deferred compensation. Compensation structure is a key
determinant to employee turnover, especially in competitive markets like New York,
London, Hong Kong, and Singapore.

Allocation of firm resources: We prefer firms that focus on a distinct or narrow area of
the global market, which generally means a firm with fewer products. We think it’s
difficult for a firm to be good at investing across all asset classes, investment styles, and
market capitalizations. A firm with a single or a few complementary products will focus
its resources, whether monetary or time-related, to that product set. When evaluating a
multi-strategy firm, we want to know how the company’s research resources are
deployed in support of portfolio managers.

Assets under management versus capacity: We view excessive asset growth as a
potential impediment to future returns and believe it is crucial that investment firms
manage their product capacity properly. For every investment product we research, we
go through an exercise to determine what we believe is a reasonable capacity for the
product. The critical factors that impact capacity are arrayed in Figure 7.

Figure 7: Investment Capacity
Investment Styles & Portfolio Construction

Portfolio Concentration Diversified # of Positions
High Turnover Low Turnover
Long/Short Investment Style Long-Only Investment Style
Private Equity Hedge Funds Traditional Management
Asset Classes

Small/Micro Cap Stocks Mid/Large Cap Stocks Government Bonds
Distressed Credit/Corporate Bonds Futures and Forwards
Small/Mid Buyout Commodities Large Cap Buyout
Venture Capital Real Estate
Master Limited Partnerships Option Contracts

Less Capacity More Capacity

Source: Wealth and Investment Management



We create an estimate of capacity for each investment product based on these criteria and
compare that number to the manager’s own analysis. We are looking for managers that
have a thoughtful plan in place regarding their capacity and whose estimate of their
capacity is both reasonable and similar to ours. We ask the question on capacity regardless
of the manager’s current size, although we are more likely to get what we deem to be the
right answer the further the manager is from capacity. Over time, our view on a manager’s
capacity may change, but any change in the manager’s investment process as a result of
asset growth or with the intention of increasing capacity raises a red flag.

Our estimates and criteria on capacity differ according to investment style and vehicle
(long-only, hedge fund, private equity). If we have any concern about a manager’s size or
impact on its markets, we review public disclosures around the manager’s ownership of
its current positions. For U.S. equities within long-only and hedge fund mandates, these
are commonly known as 13-F filings. Managers with more than $100 million in assets
are required to report the value of their long positions to the SEC on a quarterly basis,
which we can access to review any impediment created by the manager’s asset base.
Our liquidity estimate for equities is a simple formula to calculate Days to Exit:

# of Shares Owned
Days to Exit =
(Average of 3-Month Daily Volume x 20%)

Long-only managers typically provide daily liquidity. Therefore, we want to be very
careful that the majority of a manager’s portfolio could be liquidated immediately; if any
top holdings have significant days to exit, we are concerned.

Hedge funds generally offer less frequent liquidity, so we can look at the Days to Exit
versus the fund’s liquidity terms. For example, if a fund offers quarterly liquidity with 45
days’ notice, we want to make sure that the fund’s core positions can be easily liquidated
in that timeframe without swamping the market.

For non-marketable investments like private equity, the issue is not liquidity, because
liquidity is offered to investors at the manager’s discretion. The real issue is the impact
that asset size has on the opportunity set (i.e., what a manager can buy) and the ability
to create liquidity events (i.e., how hard the position will be to sell). Private investing is
unique, however, in that managers are not necessarily burdened by their asset base,
because they raise distinct funds. A manager may choose to raise a larger fund because
he/she believes the investment opportunity is substantial, but the manager also has an
ability to raise a smaller fund in the future if the opportunity set is diminished. This is in
stark contrast to traditional and hedge fund managers, who have continuous funds and
almost never retain discretion as to when to return capital to investors.

Distribution of investment products: We also focus on the distribution channels of the
manager’s products. The fewer the channels, the easier it is to manage a product’s asset
growth. We see multiple marketing relationships, mutual fund sub-advisory relationships
and consultant relationships as warning signs.



Investment Process Review
We seek to answer three critical questions when conducting due diligence on any
investment research process.

(1) Does the manager have a special advantage in the way it picks investments arising
from either the kind of information it collects or from the way it analyzes the
information? We analyze the overall distinctiveness and depth of this information
compared with other investment managers and publicly available information and data.
We also ask ourselves how the manager’s process of gathering and analyzing
information is likely to lead to superior performance under various market conditions. For
example, a manager that is able to develop a deep understanding of a company’s supply
chain might be expected to do well at times when economic growth is strong and
suppliers are facing capacity limitations.

(2) Has the way the manager uses the information to make investment decisions added
value? It is possible an investment manager’s information is identical to that of as others,
but he/she may be able to zero in on important information more astutely, or develop an
investment idea from the information that others may not see.

(3) Have the manager’s formal, explicit process, discipline and guidelines – the sell-
discipline or risk controls – added value to the overall investment process? These
guidelines can often serve as effective checks on the emotional aspects of investing;
they also help ensure that the process is repeatable.

All of our research on a firm’s investment process is designed to answer these questions
as comprehensively as possible. This is how we go about it.

Review of historical holdings and exposures: This information may vary greatly based
on the type of investment manager and product that we are researching. For a long-only
manager, this is generally a simple data request for historical securities on a quarterly
basis back to inception or at least through a full market cycle. For hedge fund managers,
there may be issues with transparency or the complexity of the underlying portfolio.
Where equities are involved, we can get historical information on the long portfolio
through their official filings with the SEC. For other types of securities we rely on
information provided by the manager that we can verify through various measures.
Hedge fund managers tend to be more secretive regarding their investments on the
short side, but we can obtain overall levels of exposures and historical information. For
private equity, we can get all of the historical positions, but because the securities are
not marketable, it is much more difficult to get relevant information about the underlying
holdings and pricing. In all cases, we are seeking to confirm that our understanding of
the manager’s investment process correlates with what has actually been owned in the
portfolio. This analysis serves as the basis for many of our questions to the manager to
assess information, judgment and portfolio construction.

Historical performance attribution: Performance attribution generally leverages the same
data and information as the review of the historical holdings and exposures, but here we
try to recreate the manager’s performance over time. We need to understand how a
manager has driven performance, so we can explain the track record and assess whether it
is consistent with how we view the organization and is replicable. For a long-only manager,
we look at the individual holdings and analyze the contribution of each security to
performance, as well as the contribution of each sector and of cash holdings. This allows us



to assess the consistency of the results and what has driven performance over a distinct
period (we typically look at calendar years). For hedge funds, we generally look at the long
positions or at key contributors to the performance of a given period, such as the top 10
contributors and detractors. For private investments we look at each investment that is
made as part of a particular fund and how that investment contributed to overall results.
We also evaluate the individual internal rate of return (IRR) and the multiple of capital that
the investment generated. We look at how individual securities impacted performance,
checking for consistency of decision-making, and we seek to verify that the track record
has been created in a manner that is consistent with our understanding of the investment
process. What we want to know is whether the manager’s historical performance is
attributable to a small number of very big winners or to a high proportion of moderately
profitable investments. The latter pattern is more likely to be replicable in the future.

Return gap analysis: This provides insight into whether a manager has added value over
a given time period and is generally applicable only to equity managers where we have
fairly full transparency into the portfolios. In effect, we begin each year (or any other time
period) with the manager’s actual portfolio and calculate the performance of that
portfolio if it were held static and then compare that static return to the actual return the
manager generated over that same time period. By linking a number of distinct time
periods together, we can ascertain whether the manager’s process adds value over time.

Active share analysis: We start with a manager’s portfolio at a point in time (and once
again, this really works only with equity managers) and focus on whether a manager’s
portfolio is significantly different enough from a given benchmark to provide an
opportunity to outperform an index fund by enough to compensate for the difference in
management fees.

Review of portfolio construction: Here the focus is on making sure that the portfolio
has met certain guidelines over time on a consistent basis. The guidelines may have
been established by the manager, such as a cap on residual cash exposure, leverage or
relative sector weightings. Or they may relate to one of our own criteria, such as our
belief that active managers generally need fairly concentrated portfolios in order to
outperform. Analyzing data such as the number of holdings, the concentration in the top
10 positions, the overall leverage, gross/net exposures and the cash weighting at various
points in time, the review focuses on verifying that the various characteristics have been
consistent over time and that the process is replicable in the future. Any substantive
change in these factors could call into question the replicability of past results.

Sell discipline: Having a viable exit strategy should be a key component of every
manager’s investment process, and we pay particular attention to how securities are
sold from the portfolio. The decision to exit a security can be just as important as the
original purchase and may be more challenging for a portfolio manager due to emotional
attachment to a particular investment or the added layer of tax consequences 5 and
other transaction costs. We review the manager’s stated criteria for sales and compare
these with the actual securities they have sold. We are looking for consistency and
accountability for these decisions.

5
Neither Wealth and Investment Management nor its employees renders tax or legal advice. Please consult with
your accountant, tax advisor, and/or attorney for advice concerning your particular circumstances.



On-site review with the portfolio manager and team: These meetings are the
culmination of all the work we perform on a manager’s investment process. They involve
a review of all of the questions that arise from the analysis outlined above, in addition to
an overall assessment of the quality of the investment process, the investment team and
the efficiency of the markets that the manager trades. At a minimum, this process
involves a lengthy meeting at the manager’s offices, although it often requires multiple
on-sites and conference calls to complete.

Analysis of Historical Track Record and Performance Statistics
Every investment organization has produced some sort of historical performance track
record over a given time period, whether it’s just a month or 20 years or more. While a
track record is an important aspect of the overall analysis, it represents what an
organization has done in the past, and we are much more interested in ascertaining what
an organization is likely to do in the future. We review quantitative data over rolling
periods that are consistent with our view of the manager’s investment time horizon,
typically between one and five years. Rolling periods tend to smooth out the results so
that short periods of substantial out- or underperformance are not given undue weight,
providing a good perspective on consistency of results.

Performance and statistical analysis versus indexes and peers: With long-only
managers, we isolate the relevant rolling period that matches a manager’s investment
time horizon and focus on the manager’s excess returns 6 , alpha, beta, standard
deviation, Sharpe ratio, information ratio, risk/reward, up/down capture ratio,
profitability, consistency ratios and correlation, comparing these statistics to the market
benchmark that best represents the manager’s investment universe. Whether the
manager made or lost money over time is important to us, but to a large degree, our
main gauge of long-only managers is in relation to the relevant market index. This is why
we accept some level of volatility and drawdown with long-only managers. But with
hedge fund returns, we analyze the return stream using shorter rolling time periods to
match shorter manager investment time horizons, and we focus on absolute returns,
standard deviation, Sharpe ratio and profitability. Here our comparison evolves to an
absolute level of return or return in excess of cash, although we also make evaluations
versus peer groups of other similar hedge fund managers.

Risk statistics: We analyze risk in two ways:

The consistency of volatility and risk-taking over time, and

The magnitude of the largest drawdown.

When comparing long-only managers with relevant market indexes, we look for
consistent levels of correlation with the market and of return volatility relative to the
benchmark over time. Of course, absolute levels of volatility in the market will change
over time, but we want to see that a manager’s positioning versus the market is fairly
stable; a “defensive” manager’s returns should be consistently less volatile than market
returns, for example. In addition, we look at what was happening in the market during
individual periods of drawdown and how well the losses were recovered relative to the
market. With hedge fund managers, the analysis of the risk-taking is more absolute;

6
See the Glossary for definitions of these and other terms.



we want to see consistent levels of volatility over time. We pay particular attention to a
hedge fund manager’s drawdowns – the reasons for the loss and how the managers
reacted. Drawdowns can be particularly difficult for hedge fund managers given their
compensation structures (incentive fees as a percentage of positive performance) and
the impact losses can have on capital outflows from the fund.

Performance statistics versus assets under management growth: As outlined above,
we think the size of a manager’s asset base can have a critical impact on performance –
with bigger not necessarily better (or worse). To make sure that as the manager’s asset
base has grown, the quality or nature of the manager’s track record has remained
consistent, we compare excess returns, standard deviation, alpha and profitability with
growth of assets over time.

Tax efficiency (if applicable based on tax status and jurisdiction): An understanding of
after-tax returns for each manager can be critical for taxable investors. We take both a
qualitative and quantitative approach to assessing overall tax-efficiency. For each
manager, we estimate the percentage of the overall return that is likely to be generated
from long-term capital gains, short-term capital gains, interest and dividends, tax-
exempt income, short sales, futures and leverage, each of which may have particular tax
consequences, depending on the jurisdiction. For hedge fund managers we can review
historical tax filings to determine how gains were classified. 7

Private equity and real estate returns: Analyzing returns of non-marketable asset
classes like private equity and real estate is as complicated as it is important to an overall
manager research process. Because returns are based in dollar-weighted internal rates of
return as opposed to the widely accepted time-weighted rate of return in the long-only
and hedge fund community, return analysis is more challenging. Dollar-weighted returns
effectively mean that a manager’s decisions over the timing of capital calls, the
deployment of capital, and the return of capital, are all significant components of the
quality of the return. The overall return generated and the multiple of capital returned
are both essential components of the return. Dollar-weighted returns can be overstated
if a small gain was generated in a very short time period, which is why using the overall
multiple of capital contributed by investors is critical. Further, there are no simple
comparisons for non-marketable managers. The industry generally uses peer groups of
other similar investments in private assets to arrive at a comparable universe. But not
only do you have to line up the investment universe, you also have to find managers who
were deploying capital in similar time periods – the investment’s “vintage” year. Thus, to
perform a reasonable analysis of a private equity manager, you’d have to compare both
the IRR and multiple of capital generated to a universe of similar investment mandates,
with similar investment time periods. Despite its complexity, it’s important to do this
analysis of a private equity or real estate manager’s previous funds because non-
marketable investment managers have, for the most part, done a better job than other
types of investment managers of replicating past strong performance in future
investments. So identifying top-quartile performance is all the more critical when dealing
with this group of managers.

7
Neither Wealth and Investment Management nor its employees renders tax or legal advice. Please consult with
your accountant, tax advisor, and/or attorney for advice concerning your particular circumstances.



Operational Due Diligence
The goal of an operational due diligence (ODD) process is to analyze and mitigate the
non-investment risks associated with any investment in an external asset
management organization.

We examine and monitor the operations of all of the investment managers we
recommend to our clients, but the most detailed ODD process focuses on hedge funds.
These vehicles pose the most obvious non-investment risks to our clients: the funds are
private placements; they have an overall lack of transparency; each fund deals with
multiple transaction counterparties and numerous external vendors; and hedge funds
have been shut down for fraud and operational problems. Our ODD process focuses on
four critical steps in coordination with the investment team.

Document and Legal Review: All private placements in the form of a limited
partnership (LP) are required to have a private placement memorandum (PPM),
limited partnership agreement (LPA) and subscription documents. These documents
provide extensive information about the offering, its investment guidelines and its
terms, all of which need to be reviewed. In addition, except for newly-created
entities, LPs will have audited financial statements, which provide information about
past performance, financial instruments used, asset valuation practices, and
comments from the auditor.

Verification of External Relationships and Vendors: Firms that offer LPs in a hedge
fund format generally have numerous external vendors, including an auditor, an
administrator, a custodian and a brokerage relationship, all of which must be verified
and reviewed to confirm that the relationship does exist as the manager has stated
and that the level of service being provided meets the standard we expect.
Sometimes certain services such as administration or custody are handled internally
or by a related party. At Barclays, we believe independent external auditors,
administrators, custodians and brokers are critical to ensuring that no conflicts of
interest exist and that non-investment risk is minimized.

Background Checks: We hire external vendors to perform background checks on a
fund’s key personnel, including investment professionals, senior employees and
anyone with discretion to transfer capital. The background checks provide
verification of an employee’s biographical details (such as education and
employment), search court records, civil findings and media records, confirm
property records and analyze regulatory bodies for any adverse findings.

On-Site Visit: Similar to the investment due diligence, an on-site visit is a critical final
part of any rigorous ODD process; it allows us to spend significant time with the
Chief Financial and Operating Officers and other senior members of the firm, and any
issues raised by the first three parts of the process can be resolved. A typical on-site
visit involves a discussion of how the fund evaluates illiquid holdings, and manages
counterparty credit exposures. We also review external vendor relationships, the
organizational structure, internal administrative and accounting functions,
compliance procedures, trading operations.



For long-only managers that are in a separate account or regulated mutual fund
structure, our emphasis is on the firm’s trading and execution capabilities, its governance
structure and disaster recovery. This is because we have transparency into holdings, and
may even custody the assets ourselves, so proper checks on fraud or manipulation of
assets are already in place.

Some aspects of the process differ for private equity and real estate managers because
we are dealing with non-marketable assets that are not generally held or valued on a
regular basis by an external custodian. Here, our ODD process emphasizes document
and legal review, valuation procedures, cash flow policies and background checks.

We firmly believe that an independent operational due diligence process is a critical
component of any manager research effort. Our investment and operational due
diligence processes are integrated and overlap to ensure we have proper checks and
balances while conducting our research. At the end of day, an operational process tends
to be “pass/fail” oriented; if we don’t have a comfort level with the operational structure
of any investment manager, we don’t hire them.



Ongoing Monitoring and Review
The discussion of our investment and operational processes details the due diligence we
perform prior to bringing any manager onto our platform or recommending the manager
to our clients. However, a reliable manager research process requires extensive ongoing
monitoring to make sure continued investment with a given manager is advisable. After
an initial investment, we continue to perform the following work for each time period:

Daily/Weekly: We monitor news and information on our managers, in real time, in
industry publications and news alerts, to glean any information on the manager, its
employees or its key investments. We also monitor performance updates that we receive
for any unexpected developments.

Monthly: We review managers’ performance monthly relative to the standards we have
set. Performance can provide a key clue to real-time changes in the portfolio or holdings.
In addition, we monitor a portfolio’s holdings or levels of exposures, such as gross and
net exposures, top positions, or sectoral, regional, or asset class concentrations. If there
are any concerns we can’t resolve, we discuss them with the investment manager.

Quarterly: We undertake a more detailed formal performance review focused on the
relative performance, market factors that impacted the portfolio, and positions that had
the greatest positive or negative impact. In addition, we formally review any regulatory
filings. We also update our long-term quantitative analysis with the most current quarter.
We bring any unresolved questions to the investment manager.

Semi-annual: We speak to all of our managers on a regular basis; the frequency depends
on the complexity of their process and the transparency we have into the underlying
investments. The greater the transparency, the less need for direct communication. At a
minimum, we speak with each of our managers formally at least once every six months,
even if performance and results are completely within our expectations.

Annual/ Periodic: This review serves to confirm of our original thesis for hiring the
manager and every aspect of that decision. We formally review any changes to the
organization, investment process, portfolio and performance, and have conversations
and meetings with the manager. In addition we formally update our ODD analysis. We
memorialize this analysis with a formal document that is presented to the relevant
Barclays governance committee along with a recommendation as to whether the
manager should be retained, recommended for liquidation, or placed on “watch”
pending additional analysis.


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