Northern Fund's Multi-Manager Funds Bring Together Investment Managers with Diverse Styles in an Effort to Smooth Out the Ride

April 2011

Given a choice between a smooth or bumpy ride, most people would choose the less hair-raising itinerary.

Geopolitical instability in the Middle East and a natural disaster in Japan have made financial markets especially volatile this spring. The choppiness added to investor queasiness about the strength of the economic recovery, the state of government finances and the timing of bringing their equity exposure back up to normal levels.

This is where the potentially volatility-buffering focus of Northern Funds' seven multi-manager mutual funds might help. Each of the funds breaks from traditional industry practice by using multiple managers with differing investment strategies.

Exposure to diverse approaches is aimed at generating a smoother ride for fund shareholders without sacrificing performance over the longer term.

"Risk aversion is still high," said Nina Staley, senior vice president of Northern Trust's client solutions group. "Many investors know they need more exposure to equities, but they're waiting for the captain to turn off the 'fasten seat belt' sign."

Northern Trust, which has constructed multi-manager portfolios for more than 30 years, manages $40 billion in that strategy and consults on another $20 billion.

"The process requires experience, dedicated staff, technology and exhaustive research," said Staley.

The added effort could be well worth it for shareholders. Northern Funds' multi-manager investment strategy aims to reduce volatility while also providing an attractive combination of risk and return.

Lowering risk is a worthy goal, of course. But doesn't lower risk translate to lower returns?

"Not necessarily," said Staley, "especially when risk is defined by volatility."

Northern Trust senior vice president Jessica Hart, who co-manages the firm's multi-manager funds, points out that investment styles can tend to perform differently at various times in a typical market cycle.

By back-testing results generated by thousands of money managers worldwide — and then combining a select few in various proportions — Hart and her team of specialists assemble portfolios that are designed to weather the buffeting that markets absorb as economic growth rates ebb and flow.

That process may be especially valuable during periods of instability.

For example, when growth stocks take the brunt of a sell-off, the value component of a portfolio could provide attractive returns to lessen the impact. Conversely, some market environments disproportionately benefit companies with above-average growth prospects while hindering those with a value tilt.

That's why the multi-manager strategy seeks to maintain finely calibrated exposure to diverse investment strategies through money managers with proven stock-picking skills.

"No one can predict when an investment style will go in or out of favor," Staley said. "But savvy stock pickers generally remain patient stock pickers regardless of the market environment."

Seeking out specialist managers also is a differentiating factor that makes the Northern Funds multi-manager approach unique.

"We like to focus on specialist managers, whether they are in a larger, multi-strategy firm or a smaller, boutique shop," said Staley.

Keeping it active
For all its potential strengths, the multi-manager approach begs an important question: Can there be too many cooks in the kitchen?

"Too many cooks can spoil the broth," Staley acknowledged. "But we constantly analyze each portfolio to make sure it isn't a closet index fund."

In theory, that could happen because multiple managers, working independently, might end up owning a representative cross section of a market.

Of course, investors holding a potpourri of actively managed funds might be doing exactly that anyway, albeit in a less sophisticated manner.

"Diversification can be taken too far," said Hart. "In that case, investors would pay advisory fees unnecessarily. Our job is to know how many investment styles or managers is too many."

According to Hart, if an investor wanted to be fairly certain of matching a benchmark before fees, they may want to consider buying an index fund. An index fund, by nature, is a passive investment vehicle designed to replicate the holdings and allocations of its target market index.

"But that's not what we're offering here," she said. "As actively managed portfolios, the returns of our multi-manager funds have the potential to vary from their benchmarks after expenses, not just match them. Plus, an index fund also matches the market's volatility. We believe that our approach may provide shareholders with a smoother ride than they would get by using a single-strategy or index fund."

Not that matching a market benchmark is necessarily a bad thing. In fact, actively managed funds can still fall short of their benchmark over the long haul.

Hart is quick to add that actively managed single-strategy funds, as well as passive or index funds, also deserve a place in a diversified portfolio.

"They all have an important role to play," she said.

Selection process
Northern Funds' multi-manager sub-advisers are not thrown together just because they're different. Managers are selected after a grueling analytical regimen that begins with analyzing a collection of highly advanced metrics.

"This is not something that most individual or institutional investors could do on their own," said Staley.

Several factors come into play.

The Northern Trust research team examines each manager's active share, a statistic which quantifies how their holdings vary from an applicable benchmark.

As its name implies, active share refers to that portion of a manager's performance that can be attributed to active management — primarily stock selection — and not from simply mimicking a benchmark.

An active share of 100%, for example, indicates that the portfolio is completely different from its benchmark, both in terms of holdings and allocation.

"You need to be different from the benchmark to potentially outperform it," Staley said.

Equally important, active share separates the proverbial wheat from the chaff when it comes to picking stocks. After all, the ability to access a company's long-term potential relative to its current stock price goes to the heart of investing.

"Looking at the active share component tells us if managers are just trying to look like their benchmark, or whether they're really adding value through astute stock picking," said Staley. "We want managers who have performed well because they picked the right stocks, not because they've simply jumped on a moving train going in the right direction."

While high active share scores are desirable, Staley and Hart want low correlation scores between their sub-advisers. Correlation measures the tendency of two or more items to move in tandem. When constructing a multi-manager fund, low manager correlations are a plus.

The Northern Funds multi-manager team also monitors tracking error, which measures how much an individual manager's performance has deviated from a benchmark. Naturally, a large tracking error is nice when the manager is outperforming. But assigning too large a percentage of assets to that manager could be risky because their hot stock-picking hand could suddenly turn cold.

"Setting the appropriate manager concentration level is a balancing act between risk and reward," said Hart. "We don't want a multi-manager fund's performance to be overly dependent on the results from a single sub-adviser."

Trust but verify
For all its exacting initial requirements, aiming to construct a manager "dream team" is not the end of the process. Actually, it's closer to the beginning.

"We don't just hire three or four sub-advisers and close the file," Staley said. "Besides performance, there are compliance and operational issues to watch."

Each manager's trades are monitored on a daily basis. Those that don't comply with written mandates are immediately flagged for further review.

And with good reason. Even the best managers have been known to stray from their disciplines in search of temporarily greener pastures.

But given the underlying philosophy of the multi-manager approach — that short-term style shifts are unpredictable and thus cannot be "timed" — such unapproved forays are strictly prohibited.

Besides, if a conservative growth manager suddenly morphed into an aggressive growth manager, for instance, it would throw off the delicate balance upon which a particular multi-manager fund's portfolio rests.

"We've replaced managers for style drift and other reasons," said Hart.

Besides breaching portfolio guidelines, those other reasons could include personnel turnover, ownership changes, unexpected performance, inconsistent discipline, and violation of compliance procedures.

Northern Trust's manager of managers research team conducts weekly meetings to review all facets of manager performance. Conference calls with the sub-advisers are conducted quarterly, and in-person visits are made at least once each year, even if the adviser is meeting expectations.

"Ultimately, this is a people business," Hart said. "There is no substitute for sitting down with a manager and getting to know them."

Reentry vehicle
There's also evidence that stock picking could be coming back into style after a long period in which macroeconomic factors drove equity prices up and down.

"The macros still matter a lot," said Staley, "but correlations between individual stocks dropped late last year. And that could be good for our multi-manager funds, which place a high value on stock picking."

Still, Staley warns that the multi-manager approach can result in underperformance, especially over short periods when speculative fervor has taken hold. That's because multi-manager funds never have all their assets invested in the style that's red-hot.

"This program is designed for long-term investors, not traders looking to sample the flavor of the day," she said. "Since we strive to reduce volatility, the multi-manager approach can be a good way for nervous investors to reenter the equity market."

So unbuckle your financial seat belt and feel free to move among all asset classes.

Past performance is no guarantee of future performance.

Mutual fund investing involves risk, including loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level performance or guarantee against loss of principal.

Diversification does not guarantee a profit nor protect against a loss.

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