Factor analysis is core to the manager approval process.
We recently sat down with two of the biggest names in investment consulting and manager research, Aon’s Chris Riley and Morgan Stanley Wealth Management’s Michael Jabara, to talk about how they use factor analysis to help them choose which managers get on their coveted approved list. Michael’s team of 65 analysts cover around 3,000 products from mutual funds, SMAs and ETFs to offshore vehicles, Hedge Funds and CITs. Chris’s team of 130 researchers cover vehicles across the asset class spectrum from equities to private placements using a blend of quantitative and qualitative analyzes. Bottom line: Morgan Stanley and Aon use Factor Analysis in Manager Selection.
The conversation focused on a few key points:
- Factors are applied to every fund, regardless of whether the manager uses factors in their stock-picking process, or not.
- They look for consistency between the manager’s investment thesis, the stocks they pick and the factors they expose their investors to.
- Technology matters: both firms use technology tools like Style Analytics’ to examine funds with both detailed holdings-based analyzes, and less granular returns-based analyzes.
- Advice to managers when pitching them, like: proactively share your factor footprint and explain how you deliver alpha above the factor exposures.
We broadcast this as a webinar, attended by over 400 professionals on March 10, 2021.
Starting about five years ago, factor analysis has quickly become an integral part of the manager review and research processes both firms use in evaluating managers. Both Michael and Chris agreed that they can have in-depth conversations with some managers about their specific factor exposures, but not enough managers proactively provide a factor analysis of their funds, something which would be helpful to the conversation (hint: this is a good way to make a positive impression). For those managers who don’t use factor analysis, the conversations often become more educational about how they are being evaluated from a factor perspective. These managers may be surprised to learn that factor analysis is applied to their funds as part of their evaluation and comparison to other funds.
Technology Makes All the Difference
Both Chris and Michael reflected on their heavy use of technology to evaluate the factor skews of each manager they examine. Referring to the technology as ‘a godsend,’ Michael spoke about how important it is to identify how a manager positions the portfolio and how he actually generates returns. For example, prior to the recent rotation, some Value managers were picking Growth stocks to help boost their returns. Using a holdings-based factor tool, Morgan Stanley can identify exactly how managers are actually making their money.
Chris also agreed that technology has come a long way and that holdings-based factor analysis is very helpful for identifying factor skews and style drift. Identifying any mismatch between what a manager claims to be their investment thesis and the factor signature they actual hold in the portfolio is valuable to both of these manager research teams.
What do Morgan Stanley and Aon look for in managers?
Both panelists described the importance of manager discipline in sticking to their investment approach, and that factors can directly help measure such discipline. Their conviction level about a manager is dependent on that manager’s adherence to his investment style, so any deviation requires a compelling explanation.
Importantly, managers have to provide a consistent factor exposure / investment style and generate alpha above what their investors could get from a lower-fee ETF.
Both Morgan Stanley and Aon have a team of analysts performing factor analysis on every manager they evaluate. Sometimes these analyzes reveal inconsistencies, and sometimes they validate the manager’s investment thesis. These analyzes also explain the fund’s performance.
But unlike other analyzes, Morgan Stanley and Aon are not reliant on managers’ self-reporting of factor information and they can determine it themselves. That independent factor verification is an important part of the process.
Both firms mentioned how refreshing it is when a manager presents them with independent factor analysis, especially when it matches what Morgan Stanely and Aon themselves have produced. Such confirmation quickly builds trust in the manager’s presentation.
What do they do with managers who don’t use factors?
Whether or not managers use factors, whether or not managers like factor analysis, it is part of the conversation. In fact, it may be even more valuable to perform factor analysis on a manager who doesn’t use factors explicitly because they may have unknown outlier exposures to some factors. Similar to a doctor seeing a patient who’s never had their cholesterol measured, it’s even more important to do so.
This pointed out that even if factor analysis isn’t relevant to the manager’s stock picking or risk management process, it is still useful for comparing managers to one another.
What advice do Morgan Stanley and Aon have for managers pitching to them?
When speaking with Michael from Morgan Stanley and Chris from Aon, their direct advice is:
- Identify each factor skew and tease-out the stock-picking benefit above and beyond the factors. Since investors can get factor exposure with inexpensive ETFs, they want alpha above and beyond those factor exposures. Show us that you do exactly that.
- Tell us how you think about stock-picking and show us that you do exactly what you say.
- Arm yourself with your factor footprint. Explain to us how and why it’s changed over time. We’re going to get the data anyway, so if you can pre-emptively explain to us how spikes or dips in the factor profile connect with your investment thesis, that’s going to be a very good story to tell.