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Selecting an ETF Managed Portfolio – Part One: The Firm and Its Operations

Understanding a company’s business model is the key to a successful long-term partnership.

Andrew Gogerty, 04/19/2013

When selecting an ETF managed portfolio, it may be counterintuitive to start one’s due diligence at the firm and operational level. But many of these boutique asset managers began as registered investment advisors or financial advisory teams themselves, and over time they have evolved along the spectrum between RIA and traditional asset manager. These firms, for the most part, remain relatively small, entrepreneurial operations, not global asset-management conglomerates. True, to access these strategies, advisors technically just allocate client capital to decision-making processes; but in reality, an advisor and client are forming a long-term partnership with the entire firm. The basis of the investment strategy is often what shapes a firm and its outlook, so it’s important to know more than just how and when a portfolio change is executed. 

Moreover, if one strategy implodes or underperforms at an investment bellwether like Fidelity or its largest peers, in all likelihood the firm still will open its doors for business the next day. But for a boutique, the future may not be as certain. As such, it’s critically important to go beyond the strategy you are buying and find out exactly who you are investing with. 

Get the Big Picture
In short, culture matters. Whether investing client capital in a boutique or an entrenched player, investment and operational cultures inform what makes a firm run and where its executives stand on key priorities. Insight into the decision-making processes at the firm level ultimately will impact the review of an investment strategy under consideration. Successful firms have continuity in both the business operations and investment strategies. If there has been change, either sudden and large or small and over time, pragmatically evaluating how it impacts the firm going forward is paramount. It is important to review key aspects such as:

Ownership – Identify the key owners of the firm, looking past titles and corner offices. The title of president or CEO doesn’t automatically equate to a majority or even a material vote in a firm’s business or economic decisions. Review how flat or concentrated the firm’s equity ownership is across all employees. Widespread employee ownership has the potential to lower turnover, as more individuals benefit as the firm continues to succeed. If the firm is not 100% employee-owned, what is the capital structure and what are the rights of the outside owners? How long are they expected to remain owners? Outside owners with short to intermediate time frames may look to exert control in both the investment and firm operations if cashing out is the ultimate goal. 

In a related vein, find out what makes the key executives tick. What is their view of the firm’s identity? How do they describe the firm’s core value proposition? From a business (or noninvestment) perspective, what practical experience do they have? The ETF managed portfolio industry is growing quickly, so business experience and acumen will be just as important to a firm’s success as delivering an outperforming investment strategy. 

Employee Incentives and Turnover – In a rapidly growing industry with relatively low barriers to entry, firms must combat physical and intellectual turnover. It’s relatively easy for individuals and teams to break away from their current firms and take their quantitative investment models with them. As a result, one must understand the potential for wholesale or even gradual change at a firm. For key investment and noninvestment positions (CEO, CIO, president, head of sales, and so forth), know how their equity ownership structure would change should they leave the firm. For example, do they get to keep the equity? Also, ask for a timeline that shows who has been in these roles and for how long. If there’s been turnover, who were the previous two people in the roles and where did they go? 

Other aspects of employee retention are personal service contracts and non-compete agreements. In a nutshell, service contracts require an employee to remain at a firm for a specific period of time, often with substantial financial penalties should he or she decide to leave before the contract expires. Non-compete agreements typically state that an employee cannot engage in the same business or go to a competitor for a period of time (typically 12-18 months) upon leaving a firm. Such agreements provide a picture of incentives for a company’s key personnel.      

If a firm has recently gone through any change in ownership (merger, buyout, spin-off, capital infusion, etc.), the new ownership agreement is especially important. Conflict can be a sign of erosion in a firm’s culture. If key executives (both investment and noninvestment) begin to trickle out the door, something may be afoot with the company’s culture. Bottom line: Examine any outward examples of change and understand the incentives of those in key positions within the firm.

Andrew Gogerty is the ETF managed portfolio strategist at Morningstar.

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