MUTUAL FUND DUE DILIGENCEPresented to FIRMA By R. James Hrabak, CFAMarch 28, 2012

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.

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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.

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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.

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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

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Active vs. Passive Management

Active Management

•Pros•Alpha Generation•Differentiate through investment performance•Differentiate through manager selection•Cons•Tracking error•Higher cost•Labor Intensive

Passive Management

•Pros•Low Cost•Low Labor Commitment•Less emphasis on performance•Cons•Virtually guaranteed to underperform benchmarks•Less ability to differentiate IM process

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

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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

Mutual Funds•Pros•Large Universe•Access to many well-established managers•Still best avenue to pursue specialized active management•Cons•Higher expense ratios•Redemption fees are possible•Share class confusion•Desired fund may be closed to new investors

Exchange Traded Funds

•Pros•Low Cost•Growing market•Drawing positive media attention

•Cons•Actively managed options limited•Potential tax pitfalls (K-1s)•Tactical trading may be costly

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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

Large Value

Large Blend

Large Growth

Large Value

Large Growth

Large Value

Large Growth

Large Blend

Mid Value

Mid Blend

Mid Growth

Mid Value

Mid Growth

SMID Value

SMID Growth

SMID Blend

Small Value

Small Blend

Small Growth

Small Value

Small Growth

Example of Style Categories, Domestic Equities8

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

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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

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SUPERIOR RISK-ADJUSTED RETURNS

STYLE CONSISTENCY

LOW COSTLONG-TERM

TRENDS

What are the best funds in the asset class universe based on our metrics?

How do the best funds differ from each other?

What factors explain the best funds’ outperformance?

Is the fund manager’s philosophy aligned with the firm’s?

What are the insights/concerns of our group regarding the fund under review?

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?

Mutual Fund Due Diligence Process11

NEAR TERM: 1 yr returns above

Category Average

MEDIUM TERM: 3 yr annualized returns

above Category Average

LONG TERM: 5 yr annualized returns

above category average

Command Field NameOperato

rValue

  Morningstar Category = Large Value

And Total Ret % Rank Cat 1 Yr <= 50th percentile

And Total Ret % Rank Cat 3 Yr <= 50th percentile

And Total Ret % Rank Cat 5 Yr <= 50 percentile

And Max Front Load = NAAnd Deferred Load = NAAnd Std Dev 3 Yr (Mo-End) <= CAT AVG

And Annual Report Net Expense Ratio <= CAT AVG

And Turnover Ratio % <= CAT AVGAnd Manager Tenure (Longest) >= 5 years

TOP SCREENED

FUNDS

Best funds in category universe

based on our metrics

Mutual Fund Due Diligence Process: QUANTITATIVE ANALYSIS

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QUANTITATIVE ANALYSIS

Screen Group created

QUALITITATIVE ANALYSIS

Screen group parsedAttribution investigated

WILL INFORM the next phase

Name Ticker Morningstar Category

Total Ret YTD:

JANUARY 2012

Total Ret 1 Yr

Total Ret

Annlzd 3 Yr

Total Ret

Annlzd 5 Yr

Total Ret

Annlzd 10 Yr

Std Dev 3

Yr

Manager Tenure

Turnover Ratio %

Prospectus Net

Expense Ratio

Exceeds Group Avg.

MFS International Value I MINIXUS OE Foreign Large Value 1.82 -1.10 15.52 -0.12 9.28 18.38 8.33 24.00 1.03 7

Tweedy, Browne Global Value TBGVXUS OE Foreign Large Value 1.78 -3.03 16.72 -0.12 6.37 14.26 18.67 12.00 1.40 7

Thomas White International TWWDXUS OE Foreign Large Value 6.38 -6.72 16.22 -1.27 8.89 22.26 17.67 41.00 1.38 6

Manning & Napier International S EXITXUS OE Foreign Large Value 5.13 -9.99 14.66 0.69 7.90 20.61 19.17 13.00 1.11 5

JHancock3 International Value Eq I JIEEXUS OE Foreign Large Value 6.65 -9.71 17.52 -2.68 7.15 21.68 13.92 12.00 1.18 4

Templeton Instl Foreign Eq Ser Primary TFEQXUS OE Foreign Large Value 5.22 -9.45 14.18 -1.95 7.37 22.75 15.58 13.63 0.81 4

GMO International Core Equity VI GCEFXUS OE Foreign Large Value 4.02 -7.72 12.95 -3.52 7.10 21.46 10.08 40.00 0.44 1

                         

DFA International Value I DFIVXUS OE Foreign Large Value 6.72 -14.88 16.64 -4.49 8.50 26.88 13.17 9.00 0.45 5

                         

    SCREEN GROUP AVERAGE 4.72 -7.82 15.55 -1.68 7.82 21.03 14.57 20.58 0.98                           

US OE Foreign Large Value   Foreign Large Value 5.66 -10.41 13.13 -4.51 5.76 22.85   45.95 1.41  

Mutual Fund Due Diligence Process: QUANTITATIVE ANALYSIS

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Mutual Fund Analytics and Selection Process: QUALITATIVE ANALYSIS

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We identified 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?

Mutual Fund Analytics and Selection Process: QUALITATIVE ANALYSIS

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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 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.

We then compared the candidate funds’ historical EM weightings and current EM caps to ensure that these funds were being managed in alignment with our expectations for our Foreign Large Cap Growth manager.

Mutual Fund Due Diligence Process: QUALITATIVE ANALYSIS

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TIMELINESS of prospective swap:• W

hipsaw risk?

• How does current Market and Sector environment affect the swap?

POTENTIAL QUESTIONS and QUALMS:• F

rom Clients

• From Investment Committee

GROUP KNOWLEDGE:• E

xperience with Fund Company

• Previous experience with similar swap/shift

MISCELLANEOUS:• D

erivates usage?

• Trading structure

• Sell Discipline

INTERNAL GROUP DISCUSSION

Q&A with Candidate

Fund PM team

Mutual Fund Due Diligence Process: FINAL REVIEW

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EXPLANATION OF OW/UW’s:• C

yclical or Structural?

• OW/UW’s Attribution?

RESPONSIVENESS of PM team• D

o we have direct access to actual PM?

REQUEST COMPARATIVE ANALYSIS with CURRENT FUND• S

ector weights, Returns, Risk

CASH ALLOCATION• T

actical or Fully Invested?

Q&A WITH CANDIDATE FUND

PM TEAM

IMPLEMENTATION of INVESTMENT

DECISION

Mutual Fund Analytics and Selection Process: FINAL REVIEW

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Asset Management & Trust Group

Featured Mutual Funds (Extract)1/31/2012

Page 1 of 2  

Name TickerYTD

Return1-yearReturn

3-yearReturn

5-yearReturn

10-yearReturn

Std Dev 3yr

Manager Tenure

Turnover Ratio

Expense Ratio

Large Cap Equity                    

Fidelity Advisor New Insights FINSX 4.91 3.53 18.37 2.82   15.67 8.58 47.00 0.89

Category Average: Large Growth   6.31 1.83 19.73 1.60 3.14 19.09   73.65 1.32

                     

American Beacon Lg Cap Value Inst AADEX 4.95 -0.16 18.19 -1.55 5.42 20.22 24.58 90.00 0.60

Category Average: Large Value   4.27 1.23 17.06 -1.46 3.87 18.96   61.14 1.25

S&P 500   4.48 4.22 19.24 0.33 3.52 18.16                           

Mid Cap Equity                    

T. Rowe Price Mid-Cap Growth RPMGX 6.20 2.47 26.56 6.23 8.54 19.86 19.67 30.10 0.80

Category Average: Mid-Cap Growth   6.79 1.19 23.33 2.73 5.40 20.93   87.94 1.40

                     

JPMorgan Mid Cap Value Instl FLMVX 4.04 5.39 22.07 2.42 9.17 18.69 14.25 41.00 0.76

Category Average: Mid-Cap Value   5.74 -0.46 22.27 0.41 6.52 21.63   58.10 1.34

S&P MidCap 400   6.61 2.71 25.26 3.90 7.78 21.68                           

Monthly Review

of Screen Metric

data

Do we see RECURRING relative underperformance?

Is the RECURRING

relative underperfor

mance improving or worsening?

Is there NEW

relative underperformance?

Mutual Fund Analytics and Selection Process: ONGOING MONITORING/REVIEW

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SUPERIOR RISK-ADJUSTED RETURNS

STYLE CONSISTENCY

LOW COSTLONG-TERM

TRENDS

Do we see RECURRING relative under-performance?

Fund put on watch listIn-depth review tabled

Do we understand the under-performance as

cyclical and expected for what we selected the

manager to do?

NO?

YES?

Mutual Fund Analytics and Selection Process: ONGOING MONITORING/REVIEW

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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

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MUTUAL FUND DUE DILIGENCEPresented to FIRMA By R. James Hrabak, CFAMarch 28, 2012