resents incentive compensation based on investment performance. Table 5.1 summarizes the results of the 2003 CFA Institute compensation survey for various investment positions in mutual fund management companies.
The Investment Management Front Offi ce 105 forecast?” Like other analysts, Sean attends industry conferences, follows the industry trade journals, and tracks breaking industry news via sources like Bloomberg and CNN. He attends several meetings per day with com- pany management or analysts.
Chris Bedowitz, also an assistant portfolio manager and analyst, covers the health care, technology, and telecommunications sectors. He echoes Sean’s description of the overwhelming mass of data that fl ows toward them each day.
Like every analyst, he has dozens of voice mail and e-mail messages, mostly from sell-side analysts and salesmen, queued up by mid-morning each day.
He faces a daily stack of mail eight to ten inches high, crammed with trade journals, company press releases, and research reports from sell-side analysts.
Weeding through all this to get useful information, Chris maintains, is the ana- lyst’s real job. He relates an analogy drawn by a former director of research:
It’s like you and every other analyst have had the pieces of a jigsaw puzzle dumped out in front of you. You don’t have anything that tells you what picture your puzzle is supposed to represent. You don’t have all the pieces to complete your puzzle. You have pieces for other people’s puzzles in your stack. People give you more pieces and take pieces away as you work. Your job is not to complete the picture—that would take too long, and would be worthless by the time you’re done. Your job is to fi gure out what the picture is before anyone else does.
INVESCO uses a team of portfolio managers for the funds, and Peter Lovell handles the equity portion of the Balanced Fund, and two other funds.
He makes both allocation decisions (how much to overweight or underweight the fund’s holdings in a sector as compared to the S&P 500), and stock selec- tion decisions. As a matter of policy, the fund holds between 50 and 60 issues, no one of which makes up more than three percent of the total portfolio value.
Peter lists fi ve criteria a company must meet before he will decide to hold its stock in the fund:
1. It must have earnings greater than the average for its sector 2. It must have a strong balance sheet
3. It must have an attractive PE/growth ratio
4. It must display some area of competitive advantage 5. It must have strong management
In addition to these factors, some of which are very qualitative, he also reviews charts of general market trends that help him evaluate the stock’s relative valuation. Invesco is a growth shop, Peter says. They look for stocks where both the company fundamentals and the earnings growth indicate that the stock price should rise.
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Like the analysts, Peter is inundated by messages—via telephone, e-mail, and mail—from the brokerage fi rms on the sell side. “They’re of limited value to me,” he says. “They all have their own agendas to pursue. I get much better information from our internal analysts.” Occasionally, he says, the brokerage fi rms are helpful in getting them access to executives of companies they might otherwise have diffi culty reaching. By and large, however, he looks for the Invesco analysts to tell him what’s going on in their sectors, what stocks look like promising opportunities, and where the problems are.
Once he’s made a decision to buy or sell, he sends the order to the traders via INVESCO’s trade order management system. The system checks the order for compliance with regulatory and prospectus rules, and if no tests fail, sends it within seconds to the trading desk. Peter says he never gives the traders any instructions to direct an order to a particular broker. Instead, the invest- ment management team—analysts, portfolio managers, and traders—meets quarterly to draw up general guidelines for apportioning order fl ow to differ- ent brokers, based on how helpful the various fi rms have been with research, trading help, and other services.
Pat Johnston, INVESCO vice president, heads the equity trading function.
In the trading room, Pat is a whirlwind of multichannel communication. Her desk features an array of no fewer than six computer screens, and she divides her attention among these, the two or three simultaneous conversations she is having with other traders in the room, and the constantly ringing telephone.
“This is a multiprocessing job,” she says, with considerable understatement.
Pat directs the efforts of six traders, who handle the 200 or so equity trades the various Invesco funds generate on an average day. She herself has been a trader for over 17 years; collectively, her team totals over 65 years of trading experience. The INVESCO portfolio managers take advantage of this experience, generally relying on the traders to fi nd liquidity as they deem best.
“Our traders are awesome,” says Chris Bedowitz, “I wouldn’t dream of telling them where to work a trade.”
Pat describes how she might work a trade, using a particular buy order as an example. Several sell-side fi rms had issued positive reports on this issue the previous day. Before the NYSE opened, she went on to AutEx, which adver- tises bids and offers to brokers and institutions like INVESCO, to see what was out there for this stock. She called a brokerage fi rm they use a great deal and with whom they have good relations, to discuss the situation. Because of the reports on this company, there was much activity around the specialist’s booth on the NYSE fl oor, and the brokerage fi rm, which also had a trader on the fl oor, could tell her what was going on. She weighed her options: She
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The Investment Management Front Offi ce 107 could put the entire INVESCO order up before the opening, but that might move the market. However, the opening price could be the best one of the day. Finally she decided to buy part of the lot Invesco wanted at the opening, and then lie back and “let the market breathe” before adding to the holding. Ulti- mately, this strategy was successful—Invesco got the shares it wanted via several trades at an average price signifi cantly lower than the closing price for the day.
“The role of the fund’s traders is different now than it was ten years ago,”
Pat says. “Then the trader was more of a clerk, simply transmitting the orders to the brokerage fi rms’ traders. Now we work the trades, and how well we do can make a big difference.” She particularly values the electronic markets (they use Instinet and B-Trade) for their low cost, and even more importantly, the anonymity they provide. “If I want to sell a big block and I show that to a broker, I know I’ll start seeing bid levels go down almost immediately.”
The electronic markets have had a big impact, she maintains. “Trading has changed more in the last year and a half than it did during my entire previ- ous 15 years on Wall Street.” She points out that Invesco currently deals with 80 sell-side brokerage fi rms and two electronic networks. One of these, Insti- net, currently ranks number four in the list of brokers by trade volume, and electronic trading is increasing. She expects the trading landscape to change even more dramatically over the next few years, as the electronic networks rationalize and gain access to greater pools of liquidity.
Pat and the traders know the general guidelines for allocation of order fl ow to brokers, and they consult these when they can get the same quality of execution from multiple brokers. “We never sacrifi ce best execution to direct order fl ow,” Pat says, “but when there’s a tie, we will look to see if one broker is below its allocation for the quarter, and if so, we will direct the trade that way.” Invesco uses the soft dollar funding it gets from its order fl ow to brokers for three things: to pay for some market information feeds, including Bridge and Bloomberg; to obtain research that the sell-side fi rms provide to the port- folio managers and analysts; and to defray some of the custody fees that the funds would otherwise pay.
In late 1999, both the Equity Income and Balanced funds were very suc- cessful—both were rated four stars by Morningstar, both ranked high in their Lipper categories, and both had enjoyed net subscriptions for the year. The investment management front-offi ce team was doing well when compared to their peers in other funds. But they’re not infallible, Chris points out. “Some- times we’ll decide to sell something we hold, saying ‘the fundamentals have deteriorated.’ What that really means is that we made a mistake when we bought it. Fortunately, that doesn’t happen too often.”
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chapter 6 | The Investment Management
Back Offi ce
A provider of back-offi ce services . . . takes care of the nitty-gritty chores that nobody likes to think much about, but that must be done properly—or else.
— Carol E. Curtis (1999)1 The front- and back-offi ce functions in investment manage- ment resemble respectively the motivator and hygiene factors in Herzberg’s famous theory of motivation.2 Front-offi ce activi- ties—analysis, portfolio management, trading—determine the income and growth in value in the fund’s portfolio. They contrib- ute visibly to the fund’s performance. They resemble the motiva- tion factors of Herzberg’s theory, exciting customer attention and giving investors a reason to want to invest in the fund. Back-offi ce functions, by contrast, are hygiene activities that meet the basic requirements of running a viable fund. They cannot contribute to a fund’s return by making the value of the portfolio holdings bet- ter (although they can drag it down if they cost too much). They don’t excite anyone outside the investment management orga- nization (and few within it). But, like hygiene factors in work, they must be there—unless they are done reliably, correctly, and consistently, there won’t be a fund at all.
After the analysts have found stocks and bonds to buy or sell, and the portfolio managers have made their decisions, and the traders have implemented those decisions on the mar- kets, much work remains to be done to turn all that into value for shareholders. The trades must be carried to completion—
confi rming the various parties’ understanding of trade details, moving money, and transferring security ownership. The secu- rities themselves must be held in safekeeping. The effects of the trades must be refl ected in the securities inventory records kept by the investment advisor to support subsequent invest- ment decision making. This inventory must be kept current as the securities in it earn and receive dividends and inter-
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est, and issuers split, reorganize, and carry out other corporate actions. The results of the investment advisor’s activity must be examined to ensure com- pliance with regulatory, prospectus, and policy requirements. Reports must be prepared for internal and external parties. Carrying out or overseeing all these activities falls within the responsibility of the investment management