Mutual Fund Due Diligence

1. Mutual Fund Due Diligence Presented to FIRMA By R. James Hrabak, CFA March 28, 2012

2. About the Presenter R. James “Jim” Hrabak is Chief Investment Officer for MB Financial Bank’s Asset Management & Trust Group, where he is responsible for over $3 billion in assets under administration and nearly $1.8 billion in assets under management. His team of three Portfolio Managers and five Securities Analysts specialize in asset allocation, portfolio construction, and security selection for individual and institutional clients. Jim received a BBA., double majoring in Finance and Economics, from New Mexico State University, an MBA with a concentration in Financial Management from the University of New Mexico, and is also a Chartered Financial Analyst. Jim is a member of the CFA Institute as well as the CFA Society of Chicago.

3. General Items to Consider (Before Designing a Due Diligence Program) • What is Our Investment Philosophy? • In-House Management vs. Outside Expertise • Active vs. Passive Management • Mutual Funds vs. ETFs • How Much Style Drift is Tolerable? • Special Note: All of the above should be greatly influenced by your firm’s investment management resources.

4. The Importance of an Investment Philosophy • Is your philosophy a known commodity? • Why is philosophy important? • Due Diligence Program (and all investment functions) should reflect your firm’s investment philosophy • Don’t have a clearly articulated philosophy? The items to consider on the previous slide can serve as a guide for creating one.

5. In-House Management vs. Outside Expertise • The 1992 restatement of the Prudent Investor Act: • Allows delegation of investment management • States that investments should be viewed in the context of the total portfolio • Risk/return tradeoff is the central consideration • Firms are essentially required to seek out expertise in investment areas that improve the risk/return tradeoff in their client’s portfolios • Firms should carefully evaluate what they can do “in-house” versus what they should hire outside expertise to perform • Investing in a mutual fund (or an ETF ) is a form of hiring outside expertise • Firms should balance what they can competently and effectively perform in-house with using outside managers to complete a diversified portfolio

6. Active vs. Passive Management • The decision between active and passive is not a zero-sum game. A combination of the two may be optimal. • “Barbell” risk in lower-alpha categories such as LC Equity • Using index funds for high-volatility asset classes such as commodities

7. Selecting Types of Management Vehicles • Much like the active versus passive discussion, the decision between Mutual Funds and ETFs is not all-or-nothing. • A firm can dramatically reduce their client’s expense through ETFs, if passive management is preferred • Attention should be paid to the tax implications of individual ETFs as well as the potential trading costs

8. How Much Style Drift is Tolerable? • Style box complexity should be scaled to the IM resources of the firm • Regardless of the chosen style-box complexity, each category should be evaluated with equal rigor and frequency • Style box complexity intensifies with international equities (Developed Markets vs. Emerging + Large, Mid, Small; Growth, Blend, Value) • Selecting appropriate benchmarks is very important • A less complex style-box should lead to a shift away from category averages to the use of broad benchmarks

9. Designing a Program Around Your Firm’s Resources • Necessary resources • Manager Database/Analytics Software • Investment Management Staffing • Investment Committee to vet manager selection • To run a fund due diligence program effectively, it should be scaled to the firm’s IM resources • Active Management over Passive = More Analysis • More Complex Style-Box = More Analysis • Active vs. Passive decision is the key driver

10. An Example Due Diligence Program w/Examples • The due diligence process described in the next slides focuses on following categories • Quantitative Analysis: Returns; Risk; Cost • Qualitative Analysis: Performance attribution; Fund Manager Investment Philosophy • Final Review • Ongoing Monitoring/Review • The program is designed to be consistently employed across all asset classes/investment styles

11. Mutual Fund Due Diligence Process What are the best funds in the asset class universe based on our metrics? Are there under-performing funds in the portfolio? Is this underperformance more cyclical or structural (STYLE DRIFT)? If STYLE DRIFT is present, is it organic or synthetic? How do the best funds differ from each other? What factors explain the best funds’ outperformance? What are the insights/concerns of our group regarding the fund under review? Is the fund manager’s philosophy aligned with the firm’s?

12. Mutual Fund Due Diligence Process: QUANTITATIVE ANALYSIS TOP SCREENED FUNDS Best funds in category universe based on our metrics

13. Mutual Fund Due Diligence Process: QUANTITATIVE ANALYSIS WILL INFORM the next phase

14. Mutual Fund Analytics and Selection Process: QUALITATIVE ANALYSIS

15. Mutual Fund Analytics and Selection Process: QUALITATIVE ANALYSIS Weidentified a period of sustained underperformance combined with above average risk in our Foreign LC Growth fund (BIGIX). After reviewing the data, we linked this period of outlier underperformance to the fund’s significant OW in EM. Once we identified this style drift into the EM space of our Foreign Large Cap Growth manager, the questions we asked ourselves: CONSISTENT or TRANSITORY? ALIGNED WITH OUR EXPECTATIONS FOR OUR MANAGERS?

16. Mutual Fund Due Diligence Process: QUALITATIVE ANALYSIS We verified that BIGIX’s EM style drift could be expected to be consistent going forward, after a series of live and conference call portfolio updates with the lead PM. Our next step was to identify replacement candidates in the asset class/style box under review. (UMBWX and HLMIX) These candidates have to had made through our screen as detailed in slides 2 and 3. We then compared the candidate funds’ historical EM weightings and currentEM caps to ensure that these funds were being managed in alignment with our expectations for our Foreign Large Cap Growth manager.

17. Mutual Fund Due Diligence Process: FINAL REVIEW Q&A with Candidate Fund PM team

18. Mutual Fund Analytics and Selection Process: FINAL REVIEW IMPLEMENTATION of INVESTMENT DECISION

19. Mutual Fund Analytics and Selection Process: ONGOING MONITORING/REVIEW

20. Mutual Fund Analytics and Selection Process: ONGOING MONITORING/REVIEW • Do we see RECURRING relative under-performance? • Fund put on watch list • In-depth review tabled • Do we understand the under-performance as cyclical and expected for what we selected the manager to do? • NO? • YES?

21. Final Thoughts • Mutual Fund due diligence is critical to the role of fiduciary • The process, and the overall investment program itself, should be tailored to fit the level of resource committed to the investment function • A well documented and consistent review process can be a major selling point to prospective clients • Altering the perception of “outsourcing” to one where the firm is actively “managing” its managers

22. Mutual Fund Due Diligence Presented to FIRMA By R. James Hrabak, CFA March 28, 2012