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Manager Selection Undergoes Sea Change: Sideways Market Leverages Expert People Pickers'

As Wall Street continues to stabilize after a prolonged bear market and the mutual fund scandal remains top-of-mind among industry executives, the scrutiny behind selecting a portfolio manager has heightened, as has the popularity of the professionals tasked with making such decisions.

A new study from financial services advisory firm Cerulli Associates, "Professional Buyers and Manager Selection," explores this new dynamic and reveals that although there may exist a litany of approaches to conducting manager research, the fundamental manner in which firms hire and retain quality talent, the way they segment analysts, collect data, balance quantatative and qualitative data and ultimately discover new managers is undergoing a dramatic sea change.

For purposes of the study, Cerulli characterizes the analysts who play a key role in manager selection as a "professional buyer." In short, study author and Cerulli Senior Analyst Benjamin Poor explains, a professional buyer is any person or group leveraging institutional-quality research to perform manager selection. They differ from retail investors in that they put less emphasis on performance and brand name. Instead, they focus on due diligence in the selection process.

And while larger firms have had analysts on staff for such work for decades, the smaller "mom-and-pop shops," whose research traditionally hasn't extended much beyond a handful of Morningstar analytics, are now turning to the professional buyer.

"Otherwise, just as a plebian would not get an audience with the king, they're not in touch with a fund's management," Poor remarked.

Statistical evidence also suggests that professional buyers are more important these days. According to the study, consultant usage has grown 34%, use among multi-manager portfolios is up 14% and subadvised portfolio usage is up by 9.7%.

That's because, as Cerulli found, professional buyers can weed through an industry that, including hedge funds and separately managed accounts, counts some 15,000 managers.

"The problem is that you start with such a broad universe, so a lot of manager searches begin first with the quantatative numbers ... one- three- and five-year returns compared against a benchmark ... and you might look at fees and perhaps tenure, which might then leave you a few hundred. And that's where professional buyers really add their value by doing the qualitative research," Poor said.

That typically includes site visits at asset management firms, where the professional buyer would meet with the company chairman or chief executive, or perhaps its founder, or maybe the trading group and even the compliance and operations units. The number of site visits a professional buyer might make annually varies by firm, but some firms conduct upwards of 2,000 every year, Cerulli research indicates.

Industry dynamics are also driving their popularity. In a bull market, sometimes even the jobs of underperforming managers are safe; but in a sideways market, fund management has historically dialed up the scrutiny.

"Uncovering alpha can make the difference between positive and negative returns," Poor said.

The fund scandal has also increased the need for expert manager screening, while the market's recovery is encouraging fund management to loosen the purse strings.

The cost, however, can be high. The annual salary for a professional buyer with 10 years of experience, which might also include work as a money manager, is usually "north of six figures and likely includes some sort of ownership stake or partnership role that could be exercised over time," Poor offered.

That means money management firms are taking vastly different approaches to securing professional buyers, he added. Some smaller firms with shallow pockets gravitate toward new college graduates and train them from scratch. In those situations, however, the employee typically adds an M.B.A. or a C.F.A. and quickly departs for a money management post.

"But it's cheap," Poor said, noting that some firms simply concede employee turnover. "And some firms might have a particular research method that they want to emphasize, but that could also be a rationalization for the fact that they just don't want to spend the money."

Bigger firms, meanwhile, prefer a candidate with at least 10 years of experience and, perhaps more importantly, someone with portfolio management experience.

"That means they'll be better qualified to choose a money manager, because they've stood in those shoes before," Poor observed.

Also, since research has traditionally served as a stepping stone to portfolio management, landing someone with experience in that field probably means they've decided to come back to the analyst side for the long haul. For some firms, that might mean tinkering with the compensation rate. In other words, since money management is arguably the "starring role" in the financial services industry, many of the more qualified professional buyers demand a similar compensation package. That could mean allowing the candidate input on the portfolio and then tying a portion of their compensation to the success of their stock picks.

"Then you create a very different environment where everyone is seasoned, where everyone has probably been through a bear market higher overhead, but better research," Poor said.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.