Outside money managers

An outside money manager can do an excellent investment job. The problems are
that they are typically off-site, have a different investment strategy, are not your
company employees, and their credit analysis and standards may be different from
those of your company.
The investment agreement and policies and procedures for the use of derivatives
must be carefully crafted. The policies must be comprehensible, focused, comprehensive
and enforceable. We are a contract-based society. It must be clear about what
has been delegated to other institutions and what fiduciary responsibilities we have
assumed (Erikson, 1996).
As we have reviewed, compliance policies developed and implemented within an
organization should be internally consistent and provide sufficient controls. When
funds are transferred for management to a partnership, affiliate, or outside money
manager, control becomes significantly more difficult. These legal divisions must be
respected and limited partners should be cautious not to direct the business and
infringe upon the rights of the general partner and so jeopardize tax and legal benefits
of the structure.
With any investment approach, there are typically multiple objectives and these
should be ranked by priority to ensure that the manager will follow guidelines. It is
prudent to evaluate how a hedging strategy will be viewed under various market
scenarios and whether end of year results or interim mark to market pricing has
priority. An equity collar to protect a stock position, will look poorly if the equity
market rises sharply. Although collars may be a prudent strategy, performance could
be several percentage points behind an unhedged equity position on an interim markto-
market basis.
To maintain independence, an investor cannot control a manager’s credit selections
as they are made. Rather one must set up a process that reflects desired parameters.
A common predicament is when an asset is sold by the investor and yet the outside
manager may buy it as attractive. How do you reconcile that to your board? If you
sell assets and incur a tax loss, one must wait the requisite period of time before
repurchasing them or else ‘wash sale’ rules may be invoked. What happens if an
outside manager buys those same assets in the market prior to the time limit? It
may jeopardize your tax strategy.
In order to avoid ‘delegating in the dark’, the proper controls must be communicated.
After all, your controls’ effectiveness will always be reviewed post facto. Reports
may not be available until days or weeks after the end of the reporting time period.
If reports arrive by fax and have to be reentered into your systems, it’s a process rife
with error.
With money managers, the following topics are especially important to focus upon:
Ω Clearly document fiduciary relationship
Ω Explicitly outline investment policy
Ω Summarize derivatives policy
Ω Agree on methodology for tracking performance
Ω Specify credit standards
Ω Select permitted counterparties
Ω Collateral usage
Ω Repo activity/leverage
Ω Types of reports and frequency
The investment manager contract should be clear and crisply written. The fee
schedule should be clearly agreed upon. Any ‘buzzwords’ should be defined. Proxy
hedges should be limited to specific circumstances. Leveraging should be prohibited
or controlled as deemed appropriate. If the outside manager uses futures contracts,
the activity may impact the treatment/status of the investor. The futures position
may need to be aggregated for reporting purposes.
The derivatives policy should be clearly summarized. Note that separate investment
guidelines and derivatives guidelines are commonly prepared for external managers.
Also the external manger should provide the client with a derivatives strategy statement
citing types of derivative to be used and for what purpose(s). The strategy statement
should be signed by the board of directors or its designate. The derivatives
products allowed should be clearly stated. Some firms categorize derivatives by level
of risk and depth of market. These categories are not permanent classification since
markets may become more developed over time, e.g. credit derivatives. In one classification
schema, ‘A’ derivatives are liquid and standardized products, ‘B’ are semi-liquid
and customized, and ‘C’ are leveraged or exotic products and so off limits. There is
room for the ‘B’ and ‘C’ products to migrate over time to a higher status. Limitations of
hedging to transaction specific as opposed to macro hedges should also be enumerated.
The methodology for tracking performance should be explicit. What is the benchmark/performance objective and how frequently can the portfolio rebalance?
What are investment guidelines, asset selection methodology, and portfolio composition/
allocation ranges? Define duration and spread parameters. What are the gain/
loss constraints? Tax guidelines? How will income be reinvested? It takes time to
invest sufficient amounts of money to achieve diversification. When do the standards
as to diversification kick in? Are you monitoring all purchases or the aggregate
impact on the portfolio?
Credit parameters are a common area of dispute. Is subordinated or junior paper
permitted? Is the credit test simply at inception or is it a maintenance test? Quality
ratings for individual securities and total portfolio? How are split ratings handled? If
a downgrade occurs, is there an automatic sale provision or is each investment
considered separately? Permitted counterparties are a companion issue. Must they
be from the same approved list of the investor or can the investment manager make
his or her own determination?
Collateral usage brings with it all the issues of monitoring, valuation, custody, and
rehypothecation. As the investor, you are one step removed from the investment process
already and this adds another layer of complexity to the outside manager. Repo
activity, leverage, and the writing of covered calls are all methods of enhancing income.
Depending on the risk tolerance of the investor and how restrictive the fiduciary guidelines
that the investor must follow, these may be avenues open for pursuit. 508