On an equal footing

Credit analysts and portfolio managers often make for uneasy bedfellows. Analysts feel, sometimes justifiably, that their contribution is undervalued. To solve this problem, some fund managers have taken to combining the two roles, as Laurence Neville discovers

Credit analysts are a curious bunch. Occasionally eccentric, often bespectacled, always enthusiastic about the sort of details others wouldn’t notice, they are necessarily bookish people. But some analysts are angry. They feel that prima donna portfolio managers get all the recognition for their hard work while they are ignored.

Fund management firms have a variety of ways of structuring analysts’ input and of rewarding them. Traditionally analysts have played second fiddle to portfolio managers – their advice can be taken or cast aside on the whim of the manager – and their careers are of secondary importance. As Simon Pilcher, head of fixed income at M&G, notes: “There has always been an assumption in our industry that being an analyst is just training to be a fund manager.”

But a number of firms have now blurred the roles of analyst and portfolio manager. Similarly, several traditionally structured firms claim to have enhanced the status of their analysts. But are there any advantages in merging portfolio manager and analyst responsibilities? Or is it better to maintain a distinct division of labour? Perhaps most importantly, does it really matter as long as the set-up gets results?

The way in which the UK credit market has developed plays a major part in the style of credit fund management in many investment houses. At many houses, portfolio managers were originally gilt managers who then moved into credit. “You should remember that the UK credit market is still relatively young and until recently was not a career in its own right,” says Simon Mungall, investment research at Aon Consulting.

In many investment houses, this status quo has carried on into the credit era. Portfolio managers are deemed to occupy a higher place in the pecking order than analysts, who exist largely to provide a list of eligible securities. This approach understandably upsets many analysts and can also create significant problems, according to Joseph Hamilton, an associate at investment consultant Hewitt Bacon Woodrow.

“There can be a danger that fund managers might not understand the depth of the analysis given to them and might not be willing to dig deep into the research.” Instead, fund managers might focus only on the recommended valuation and the current valuation, making their decision based solely on those parameters.

Hamilton adds: “Even worse, they may trade simply on gossip rather than fundamentals.” Houses where portfolio managers are presented with a list of approved credits and then left alone to make investment decisions may be at a greater risk of ignoring the usefulness of credit research.

A distinct division between portfolio management and analyst roles can also weaken the attributes of both groups. “Where a portfolio manager is responsible solely for the portfolio and simply reviews the research which is provided to him, there are problems in marrying fundamental research and relative value,” says Maximiliano Ramirez-Espain, investment research at Aon Consulting.

Andy Gadd, head of research at Lighthouse Group, a UK retail investment advisor, says that he favours fund managers that have worked in a variety of different roles so that they understand how liquidity is important to a portfolio or how stock picks are made. “There is a danger that fund managers can get their jobs without this understanding,” he says.

A further problem can be risk management. If a manager does not interact with analysts, there needs to be a second line of defence. “For example, if spreads widen beyond a certain point, an internal alarm is signalled alerting the manager to bring the analyst back into the process to go over the fundamentals,” says Hamilton.

But M&G’s Pilcher says that the dangers of separate fund manager and analyst roles can be overstated and problems would only occur if a firm already had personnel conflicts. “The danger of separating the roles is that the analyst may live in an ivory tower removed from the world of relative value and that fund managers may ignore the input of analysts. But that would only happen if the analyst input is poor or if the fund managers were arrogant loners.”

In recent years the slew of credit events from Enron to WorldCom has woken both institutional and retail investors to the hazards of the corporate bond market following rapid growth in the sector. “A lot of investment houses saw growth in the credit space and moved into it only for their clients to become increasingly concerned about default,” says Aon’s Mungall. In order to counter that, the investment houses sought to reassure their clients by hiring expensive analysts. However, they did not necessarily make the effort to develop the company’s culture and process to ensure all analysts’ views get into the portfolio.

While Mungall notes that there is “not a strong culture of ‘star’ management in credit compared with equity” and that “most decisions are team-based to some extent”, star names are becoming more important in the retail market. Paul Causer at Invesco and James Gledhill at New Star, who run corporate bond funds, may not yet be household names, but retail investors often approach independent financial advisors with a specific portfolio manager in mind.

“Two years ago credit portfolio managers were not star names,” says Ken Rayner, head of product development at retail financial advisor The Marketplace at Bradford & Bingley, “but corporate bond funds have massively increased in prominence and marketing budget over that period.”

Lighthouse’s Gadd agrees but offers a caveat: “From a retail perspective a star name fund manager makes sales easier but it’s my job to give my clients recommendations that they wouldn’t necessarily consider themselves.”

Valuing analysts

While fund managers may get the headlines and glory, it does not necessarily follow that analysts are neglected backroom serfs at traditionally structured investment houses. Some houses have appointed heavyweight analysts and investment decisions do not get made without them.

Finding a way to improve analyst recognition seems to be more important than redistributing portfolio construction responsibilities. “Fund management [houses] would not get on our lists unless we were sure that the career opportunities for credit analysts existed within those houses,” says Hamilton at Hewitt Bacon Woodrow. “Good credit analysts should have the opportunity to do good credit analysis and get heard within an organisation.”

Lighthouse always asks fund management houses whether analysts get paid bonuses based on their recommendations – regardless of whether they are acted upon by managers. “It is important that they are rewarded as a result of their decisions,” says Gadd.

Running a shadow portfolio is one way to achieve this, according to The Marketplace’s Rayner. “Many of the firms that we respect now base analysts’ remuneration on their recommendations,” he says. Rob Marsden, head of fixed-income research at investment consultant Mercer, says that this practice benefits both analysts and the firm. “There has been a subtle shift recently at the larger firms towards the creation of [shadow] analyst portfolios.” These are a good idea from an analyst remuneration point of view and also provide a means to track analysts’ performance. “Many fund management houses have paid through the nose for research teams and understandably they want to know that they are getting value,” he adds.

According to Aon’s Mungall, the nature of the credit market dictates that analysts must be respected. Portfolio managers need to have sufficient respect for research and equally analysts require market awareness in order to make a separate approach work. Because of the asymmetric return profile of the investment-grade credit market – it has a limited upside but a substantial downside – there is a need to run a reasonably diversified portfolio. It only takes one bad investment decision to wipe out all other gains. “The implications of this in terms of the extent of sector and issuer coverage often require a team approach,” says Mungall.

One firm renowned for its less explicit division of portfolio manager and analyst roles is European Credit Management. Representatives there declined to comment specifically about the internal structure of the company, however it is well known that the firm is heavily research-focused and that while the job titles of ‘fund manager’ and ‘credit analyst’ still exist, investment decisions are made jointly on the investment committee.

A fund manager familiar with European Credit Management says: “Although the analysts do slightly more of the heavy lifting – spreading balance sheets, etc – both fund managers and analysts maintain links with investment banks, follow spreads and look for relative value.” Research is not simply tossed up to the fund management team.

He adds: “The view at European Credit Management is that they have a team of smart people on the research side and it would be foolish not to involve them in every way. More heads are better than less.” One explanation for European Credit Management’s approach may be that it is a credit specialist – it has never looked at other asset classes such as gilts. “All the focus is on spreads,” says the market observer, “and all the fund managers have a credit background and can spread a balance sheet as well as any analyst.”

Not surprisingly this system also has its critics. “No one person can do fundamental research across the whole market and make all the investment decisions,” says Aon’s Ramirez-Espain. “The breadth of the market makes it impossible.”

Even when looking at a limited investment universe, time management is a problem. The arguments against combining the roles of credit analyst and portfolio manager come down to the time spent by any manager on analysis. “Analysis will suffer and be done at the end of the day rather than as the main element of the job,” says Hamilton at Hewitt Bacon Woodrow. M&G’s Pilcher notes that combining analyst and manager roles smacks of expediency due to lack of resources.

Compromise

The consensus view among investment consultants – both institutional and retail – is that blurring the roles of analyst and fund manager throws up as many problems as separating them. Ultimately some sort of portfolio management role is necessary because an awareness of the maturity and liquidity profile of the portfolio is required and that is not a research role.

Nevertheless, Mungall says that Aon is “philosophically agnostic” with regard to which approach it favours. In its fund manager research it seeks coherence in management’s articulation of their investment philosophy and process, and then it drills down into the portfolio to make sure that it reflects the stated approach.

More important than whether a firm favours a team or individual approach is its stability and culture – specifically the ethos within the fixed-income unit, according to Mungall. “Moreover, the individuals involved must be of high quality and the process in place must capture their flair rather than hinder its expression.”

Mercer’s Marsden agrees that there is no single right approach. In his opinion, the crucial element is the chemistry between analyst and portfolio managers. “I’ve been to presentations where it was immediately clear that analysts and fund managers from the same house didn’t get on and that reveals problems in the decision-making process,” he says.

The key factor in deciding which approach to take is often size. Larger firms want separate roles because this creates a broader investment scope. For smaller firms which combine analyst and portfolio manager roles, acknowledging their limitations is crucial to success, as is the use of screening so that the universe of investment candidates is reduced. “A firm can be successful with limited resources if they are only looking at the UK credit market, but the UK and Europe together are too large to cover in that way,” says Marsden. “And including the US would just make it impossible.”

M&G: separate but equal Simon Pilcher, head of fixed income at M&G, says that looking at analysts and fund managers in isolation is too narrow a view of how fund management works. The role of dealer/trader must also be considered. The crux is to get all relevant personnel working together to improve the portfolio. At M&G the credit analyst’s job is to understand the detailed, bottom-up information and to communicate that to the portfolio manager. Their role, in turn, is to determine relative value and construct a robust portfolio. The dealer’s job is to deal and advise the portfolio manager on what is possible with regard to the market and liquidity. “[Dealers] free up the manager and the analyst,” says Pilcher. “Sourcing of assets should be left to specialists.” In credit M&G has three dealers, 10 credit managers and 23 analysts. The analysts focus on a sector or area, such as asset backed (three analysts), financial (two analysts) and industrial (four analysts), while some look at private debt, such as project finance. The premise behind dividing analyst and manager roles is that there is not enough time to cover detailed bottom-up credit work as well as portfolio responsibilities. “To understand the credit and the covenants involved in bonds is a full-time job,” says Pilcher. Analysts and fund managers sit intermingled so that communication is continuous. “We also have a credit intranet – every time there is a change to an analyst’s view an email is pumped out to everyone,” he says. “There is a push of information from analysts. It is not just on a request basis.” M&G also has more formal meetings daily and monthly. But roles remain clearly delineated. “Portfolio construction is purely a fund manager role – though they have to respect the views of the analysts and analysts must feel that they are contributing to the portfolio,” says Pilcher. “By ensuring that there is no hierarchy, it is possible to achieve that.” Ultimately, the proof of the system is portfolio performance. “If it is successful it will be a function of all contributions,” says Pilcher. “Valuing the analyst’s input has to be subjective to some degree. I do not agree with running a shadow portfolio based on analysts’ recommendations because our real portfolios do not ignore the recommendations of analysts.” Analysts need two things: to have good insights, and to be able to communicate those insights to fund managers, according to Pilcher. If they are successful at the latter, their recommendations will be followed. That does not mean that analysts’ views are not challenged: many of the fund managers at M&G have strong analyst backgrounds and the more credit intensive the portfolio, the more analytical skills the manager will have. “There is a rigorous debate between analysts themselves and between managers and analysts,” he says. “We have a culture where to question is not to insult.”

Aegon: playing as a team Everyone in credit at Aegon Asset Management is involved in both analysis and portfolio management, according to Daniel McKernan, head of credit. “This builds a strong sense of ownership – the person running a portfolio has the final say in what goes into it but those choices are made as a team, the idea being to ensure that there is relative value in funds.” McKernan explains that at Aegon “individuals wear two hats: they run a portfolio but also make recommendations for one or more sectors.” He adds: “They are better at both jobs because they know how the other works. They know the cost of dealing and the relative value concerns.” He concedes that this can create problems, specifically that there is a risk that analysis will be neglected because people on the team have to follow their stocks during the day. “But everyone realises that you need to make time to do in-depth analysis and because people follow a sector in addition to their portfolio there is team pressure to provide ideas.” In order for a stock to make it into a portfolio at Aegon, an individual must pitch it to other colleagues. In instances where people might want to put their own recommendations into their portfolio, a note would be put out to the rest of the team; because various colleagues shadow that sector, the individual will be able to gauge a broader opinion. Aegon has a daily meeting but stock opportunities are also emailed to colleagues immediately when they are noticed. “Colleagues would let me know if they want my recommendation on, for example, the structured finance sector, and I would then buy it on behalf of all the team,” says McKernan. The system – especially in such a small team – has its own checks and balances. “I operate an overseeing role but really everyone naturally oversees each other,” says McKernan. “If people need ideas in utilities and none have been supplied, they will ask for them.” Although Aegon only has a team of seven – a few from an equity or analyst background and a few graduates who have learnt their portfolio skills at Aegon – McKernan says resource is not an issue. “We run a lot of portfolios. If you have the right systems and run portfolios that look like model portfolios then it is not difficult.” Similar portfolios – in terms of maturity, for example – are grouped together with one fund manager. He adds: “Our talent is more biased towards the research side but everyone has portfolio skills.”