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Investment Due Diligence Process
Industry “Best Practices” for
401(k) Plans

Author: Vince Giovinazzo
Contributed by: 401(k) Advisors, Inc.


Expertise & Qualifications

Fiduciaries of qualified plans are required “to act with the care, skill, prudence and diligence under the prevailing circumstances that a prudent person acting in a like capacity and familiar with such matters would use.”  Over time this has evolved to become known as the “prudent expert” rule.  Fiduciaries lacking this type of knowledge (conceivably making them an “expert”) are directed by the regulations to hire one.  Unbeknownst to them, this is where many fiduciaries have failed to meet the mark, due to the widely held acceptance that registered representatives and/or registered investment advisors (RIA’s), are “experts”, when, in fact, the standards they must meet are minimal in scope and content.

Commonly perceived by the public as an investment “expert” is someone known as a “registered investment advisor” (RIA).  The requirements to become a “registered investment advisor” (RIA), are minimal at best.  An individual does not need an insurance or traditional securities license.  The only exam that an RIA must pass is a Series 65 or 66.  No investment training or demonstrated skill level is required.  At the firm level, the firm needs to complete a series of forms (the ADVII and Schedule F), and filing with either the state(s) in which the advisor is doing business, or the SEC. 

An NASD registered representative (Series 6, 7, and 63) is required to demonstrate more investment expertise through the exam process than an RIA! Therefore, our first conclusion is that RIA’s do not, by virtue of their title, have any greater inherent investment knowledge than registered representatives or even insurance licensed agents. 

It is widely accepted in the investment community that the most knowledgeable individuals in the field of investments are Chartered Financial Analysts (CFAs).  Attainment of the CFA designation requires passing three different exams (level I, II, and III), and successful completion of practical field/work experience.  It typically takes a dedicated individual five years or more of rigorous study and practical experience to attain their CFA designation. 

Many investment professionals, including fund managers and research analysts are CFAs.  These individuals are responsible for trillions of dollars of institutional and non-institutional assets.  In fact, the SEC provides CFAs an exemption from passing certain securities exams as a tacit admission that attainment of this designation makes these individuals more than qualified with respect to the qualifications needed in becoming NASD registered representatives and/or RIA’s.

All of the reports, analysis, Scorecards ™, and recommendations delivered to clients of 401(k) Advisors are prepared by a CFA level consultant.  Our Chief Investment Strategist, Jeffrey Elvander, CFA, has over 10 years of industry experience, managing, consulting, and working with billion dollar plans and asset pools.  His industry experience and knowledge is applied to the entire investment consulting practice at 401(k) Advisors.

All this to say that the expertise and qualifications of a CFA are far superior to that of an RIA.  Their knowledge of math, quantitative analysis, and general investment principles allow them to deliver far more scientifically based recommendations and analysis than an RIA (or registered representative for that matter), who prepares investment analysis and research on their own.

Investment Research Software

There are two types of investment research software:  Analytics-based software and data-based software.  Analytics-based software is dynamic, giving the investment professional the flexibility to look at rolling periods, calculate multiple statistics, and, most importantly, the ability to measure the significance of skill, as it relates to a fund manager.  The flexibility of this type of software gives CFAs and other investment professionals a powerful tool in examining fund strategies in many different lights.

Morningstar Principia, for example, is a data-based software package, delivering standard quantitative measurements such as alpha, beta, expense ratios, performance, and other common statistics.  While much of the material supplied by Morningstar may be useful, the flexibility for a detailed analysis is limited to the scope of the data provided (analytics-based software allows the user to run statistics and perform style analysis based on the requirements of the user). 

Morningstar Principia simply does not deliver enough meaningful and comprehensive information to the investment professional to be used as the sole or primary investment tool in the analysis of 401(k) plan investments.  A “Best Practices” method should give the investment professional the resources to leverage the full power of an analytics-based tool to fully evaluate a manager’s strategy (i.e. was the fund’s performance due to skill or luck).  Scores or ranks supplied by data-based systems need to be evaluated closely to understand their calculation, and ultimately, their flaws.  One ranking system is not an end all and be all to all, including fiduciaries.  Many have flaws, depending on the goals or objectives of the investor.  A tacit admission of this has been stated by Don Phillips, Morningstar’s President, when he admitted that Morningstar’s “three star” funds actually have outperformed their “four and five star” funds consistently in many market cycles.

In reality there are THREE industry-standard software programs:  Zephyr Style Advisor; Ibbotson Encorr and; MPI Stylus.  They are very expensive, very comprehensive, and require significant skill even to operate the software.  Use of one of these programs would be consistent with at least one “Best Practices” ingredient.  Morningstar’s information is included as part of the analysis and research offered with each of the above programs; however, it is not the key driver for most of the calculations and fund recommendations.

The Importance of Tracking Style Attribution

The obvious question is WHY are the above programs an indication of “Best Practices”, where Morningstar and other basic research tools are not.  For the answer, we can look to the Brinson, Hood, and Beebower study that evaluated the following components that collectively determine an individual’s overall portfolio return on an aggregate basis:

  • Market Timing

  • Fund Selection

  • Asset Class (Fund Style)

The results concluded that market timing and proper fund selection accounted for less than 10% of total return (variation), while greater than 90% is based on the asset class, i.e., fund style!  Embedded in this conclusion is that proper asset allocation is the key driver to maximizing return while minimizing risk. 

The next obvious question is how to construct a portfolio of investments that have the proper asset allocation.  There are two key drivers to constructing proper asset allocation:

  • Identifying fund style

  • Identifying the appropriate percentage and number of fund styles for the desired risk level

Again, we attempt to answer why Zephyr Style Advisor, Ibbotson Encorr, and MPI Stylus are consistent with industry “Best Practices”, and why programs like Morningstar alone are not.  The answer is that the former (three) programs identify the behavioral characteristics of fund style, and provide tools to construct proper asset allocations, while other data-based programs, such as Morningstar Principia, do not. While Morningstar Principia may provide investors with the fund’s stated style, or even an analysis based on the fund’s recent holdings, Zephyr (the program used by 401(k) Advisors), and the others (mentioned above), analyze the behavior of the fund regardless of its stated objective or holdings.

The above distinction is critical.  The analogy here is the difference between what someone says they are doing to what they are actually doing.  Additionally, these conclusions need to be measured over time, as a single data point does not tell the whole story. 

The Importance of Proper Asset Allocation

Remember our (above) two key drivers to constructing each asset allocation - fund style and the appropriate allocation to each fund style.  We have already established that Zephyr has the ability to identify the behavior of a fund, while programs like Morningstar Principia do not. 

The next “Best Practices” ability of an investment “expert” is the ability to construct the optimum portfolio of investments for a desired risk level.  Many refer to this as the “efficient frontier”.  Typically three to five asset allocation portfolios are constructed and offered to employees, ranging in target risk/return from “conservative” to “aggressive”.

The key to attaining the goal of MINIMIZING risk and MAXIMIZING investment return with each portfolio is a combination of investments with the appropriate fund STYLE and PERCENTAGE for each fund style.  For example, if an allocation calls for 20% Large Cap Value, it is imperative that a fund be chosen that actually behaves, i.e., performs like a Large Cap Value Fund.  Analytics-based software, such as Zephyr, identifies those funds that perform in-line with the parameters of a large cap value style.

There is a common counter-argument often asserted by many non-investment professionals, that goes something like this:  If we take the best performing fund that Morningstar has identified, for example, as “large cap value”, even if it behaves and acts like a “mid cap growth” fund, it is still the best fund for our allocation due to the fact that it was chosen based on “top performance”. 

This argument has zero basis, scientifically.  The reason has to do with correlation, which can be “positive” or “negative”.  With positive correlation, performances of different funds tend to move in the same direction.  For example, there is a high correlation between the average Large Cap Blend Fund, and the S&P 500 index (which is by definition in the Large Cap Blend category).  There is a lower to negative correlation between the yields of stable value funds and the share price value of bond funds.

The Brinson, Hood, and Beebower research concludes that greater than 90% of the return variance is based on the proper asset allocation, which is based on the correlations among all of the underlying funds in the asset allocation.  If our asset allocation calls for “20% Large Cap Value”, and the actual behavior mirrors a typical “MID CAP GROWTH” style, the result could lead to an un-optimal allocation.  In turn this will result in an asset allocation that has either:  HIGHER risk at the SAME projected investment RETURN level or; LOWER return at the SAME projected RISK level.

The Importance of Separating Returns in Up and Down Markets

There are many quantitative factors that imply industry “Best Practices”.  Two inter-related and well-respected statistics are “up capture” and “down capture”.  These measurements quantify investment return during periods of up markets and down markets.  Each statistic is tracked separately. 

What is more important than the ABSOLUTE return of the fund, is the RELATIONSHIP of fund performance in up and down markets.  A passing score would be given to a fund whose “up” capture is GREATER than it’s “down” capture, relative to its benchmark. 

A fund that does not perform up to the benchmark in “up” markets can still be an appropriate if not excellent fund, if its performance in “down” markets is less volatile (has a lower “down” capture than “up” capture).  The T. Rowe Price Science and Technology Fund is a good example of astronomical “up capture” performance during the go-go late 1990s.  Yet its “down capture” in down markets was even greater than its corresponding “up capture” figure.  This analysis alone would have caused this fund to be eliminated far sooner than simple “alpha” or “beta” or other similar analysis.  In conclusion, a fund with a greater “down capture” number than “up capture number will fail this portion of the 401(k) Advisors Scorecard ™.

A Preponderance of Information

The 401(k) Advisors Scorecard ™ has eight quantitative factors, and two qualitative factors.  What qualifies the Scorecard ™ as part of an overall “Best Practices” process is the depth and scope of information that is applied to every fund.  Each fund is scored on a 0 - 10 basis.  30% of the total score is style related; 30% risk return; 20% peer group; and 20% qualitative.  401(k) Advisors includes the following metrics in our Scorecard ™:

  • Upside capture

  • Downside capture

  • Standard deviation related to return

  • Tracking error

  • Information ratio

  • Point in time style attribution

  • Migration of style attribution over time

  • R-squared

  • Average Excess Return

  • Performance and information ratio ranking vs. peer group

These are not the only quantitative factors that can be used by an advisor as part of an overall investment analysis, however, it is the totality and relationship of all the analysis that collectively provides us with a preponderance of useful information.    

For example, “tracking error” is the measurement of the risk taken by the manager to achieve the excess return over the benchmark.  When investment returns are quoted in an absolute environment, there is no relationship to the risk taken by the manager.  The tracking error statistic allows us to determine “information ratio”, helping us gauge the manager’s skill level in achieving excess return over the benchmark.  Only programs like Zephyr (and the other aforementioned tools), provide these types of meaningful analysis.

Not Relying On Historical Performance As a Measurement Tool

Note that historical performance is not included in the 401(k) Advisors Scorecard ™.  Another indication of a “Best Practices” review would be any analysis that relies on the science of investing that does not heavily weigh past performance as an important factor in fund selection.

Russell Investment Advisors is the largest “manager of manager” investment advisory firm in the world.  They have concluded that there is very little if any relationship between past and future performance.  Their research is consistent with virtually every independent firm who has attempted to examine the relationship between past and future performance.  Russell separates over 400 funds in their quantitative value category into four quartiles and tracked their performance over five years.  They then examined how the top quartile funds had performed the prior five years.  Approximately 75% of the top quartile funds for the most recent five year period were in the second, third, or even bottom quartile for the prior five year period.  Conclusion:  Choosing funds on the basis of past performance is a bad idea!

Recently 401(k) Advisors was hired by a $100+ million plan that had been working with a national consulting firm.  We scored one of the funds, which was awarded a passing grade by the prior consulting firm, a “4” (which is below watch list, and generally results in a recommendation for immediate removal).  This fund had outperformed its benchmark in each of the last 1, 3, and 5 year time periods.  On the surface it appeared to be a stellar performer and acceptable fund.  Why would 401(k) Advisors score the fund “below acceptable”?

Upon closer inspection, we determined that the fund had consistently deviated significantly from its stated style, both in terms of market capitalization (large cap versus small cap), and objective (value versus growth).  In addition, we found the risk levels taken by the manager, as measured by “upside and downside capture”, “standard deviation related to performance”, and “tracking error”, to be unacceptable.  Qualitatively, the fund management team had experienced significant turnover.  The new manager did not have a strong prior track-record.  There were other factors that contributed to the low score; however, the underpinning point of this discussion is that all of the factors that resulted in a low score were the result of analysis in areas other than historical investment performance.  Morningstar alone and the typical tools used by most RIA’s, including this national consulting firm, would not have identified the underlying problem.


401(k) Advisors archives every presentation, report, and document prepared for every customer.  We separate this documentation into different categories, including:  Compliance Documentation, Investment Due Diligence, RFP’s & Benchmarkings, etc.  For example:  investment reviews, executed investment policy statements, RFP benchmarking reports, fund recommendations, our Scorecard™, and all supporting materials, are all stored in the “investment due diligence file”. 

The point is that at any time a customer or 401(k) Advisors representative can log on to our encrypted system with their password, and “point and click” to the sum total of all of the due diligence work that has been done on behalf of the plan.  A 401(k) Advisors Plan Consultant is assigned to every customer to ensure the process runs smoothly.  The consultant is required to write an executive summary of every meeting.  These meeting notes are posted on our website.

The executive summaries are more than just a retrospective review and meeting summary.  We document all attendees, their title, role (committee member, etc.).  Plan consultants also document action items generated as a result of the meeting (fund additions and deletions, changes in the IPS, etc.), and the results of the recommended action.  When, where, and how did the fund change actually occur?  What plan design changes were actually implemented and when?  How were changes communicated to participants?  This information is documented and posted in the Executive Summary.


In conclusion, this paper has identified at least 10 requirements of investment advisory firms that meet or exceed what we believe to be industry “Best Practices”:

  1. A CFA level professional is responsible for the analysis and research

  2. Analysis using quantitative and qualitative measurements other than historical return

  3. The use of many (non-performance related) quantitative and qualitative factors

  4. The use of several “risk return” measurements that quantify the manager’s risk to achieve the overall return

  5. Evaluating fund performance in “up” and “down” markets

  6. Investment tools that develop proper asset allocations

  7. Evaluation of current and historical style attribution

  8. The use of comprehensive software and tools that utilize complex quadratic optimization formulas to provide meaningful data

  9. Documentation of all current and historical investment reviews, research, and analysis

  10. Executive meeting summaries that include documentation of the agenda, discussion, meeting attendees, action items generated as a result of the meeting and discussion, and actual implementation of those action items

There are substantial differences between the investment expertise, analysis, software and other analytical tools, and methodology between “Best Practices” investment advisory firms, and those individuals and firms with far less sophisticated skills, tools, and processes.  There is strong evidence that the results and recommendations of “Best Practices” firms are superior, due to a combination of experience, training and background, comprehensive software and tools, and a more robust and sophisticated investment analytical process than the “non-Best Practices” firms. 

401(k) Advisors has the scale and financial capital to afford among the industry’s best people, processes, tools, and technology; spending close to $1 million annually on research, design, technology, and human capital.  The average investment advisory practice employs less than five people, and does not have the financial resources or scale to afford a similar investment in intellectual capital, research tools, and design.    

The above ten qualifications demonstrated by 401(k) Advisors are all examples of industry “Best Practices” in the area of investment advisory services offered to qualified retirement plan sponsors.  The Scorecard™, in particular, consists of a very comprehensive combination of ten quantitative and qualitative factors.  This data allows our Chief Investment Strategist, a CFA level professional, to make investment recommendations to plan sponsors that are based on a comprehensive body of scientific data.  Ultimately, however, it is the collective functions and expertise of an organization, many of which are detailed above, that determine whether or not “Best Practices” should be used in totality, as it relates to the organization as a whole.

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