March 2014 A better way to invest: manager selection and oversight at John Hancock Investments Leo M. Zerilli, CIMA Head of Investments John Hancock Investments Our performance success across asset classes is the direct result of our unique investment approach. Key takeaways Financial advisors and consultants face an investment management landscape that is increasingly split between industry giants and specialized boutiques. For more than 20 years, John Hancock Investments has offered a different approach, blending innovation and agility with strong risk controls and oversight. Our process is built on five pillars that together promote stewardship, strong risk-adjusted performance, and objective analysis. The result is a deeper level of diversification, specialized expertise, and strong riskadjusted performance across our lineup of funds. Executive summary Financial advisors and industry analysts bear an important responsibility when recommending investments for clients or platforms. Apart from the ever-present fiduciary risk is a business risk that comes from recommending investments that prove too volatile or that fail to deliver results that live up to expectations. Thorough due diligence is not possible based on historical performance alone, yet qualitative evaluations are hindered by lack of direct access to portfolio teams and an increasingly splintered universe of high-quality asset managers. At John Hancock Investments, we believe our manager-of-managers model, begun in 1987, offers a different approach, one that combines the oversight and risk controls of a premier asset manager with the innovation and diversity of today’s boutique manager landscape. In this paper, we review the challenges posed by the current environment and describe how manager selection and oversight work at John Hancock Investments. Behemoth or boutique? The asset management industry is both incredibly diverse and highly concentrated. On the one hand are the traditional, diversified money managers. Several of these firms were founded around the time of the Great Depression and the dawn of the mutual fund concept. All have developed investment frameworks, procedures, and support systems to manage money across multiple asset categories. These complexes generally employ large staffs of in-house portfolio managers and researchers, and enjoy the benefits that economies of scale can bring to securities trading and product pricing. However, the same efficiencies that can drive profits for the largest fund complexes are what can lead to mediocre performance over time, or a failure to see the next inflection point in the markets. When all of an asset manager’s portfolio teams rely on the same central research group, for example, it is natural to wonder whether any team can maintain a truly independent perspective. This issue of independent thinking is compounded by the fact that a single manager at a large fund complex will often run multiple funds. As Morningstar notes, “Zebras don’t often change their stripes, and managers often gravitate to the same stocks for multiple portfolios.”1 1 “How to Avoid Overlap,” Morningstar, Inc., 2010. This business model tends to lead to large swings in complexwide performance: When the firm’s research is working, it’s working, and when it’s not, it’s not working everywhere. For example, the number of boutique managers offering five or fewer funds has nearly doubled in the past six years alone, from 271 to 530.4 Asset management bureaucracies have also been shown to have a deleterious effect on innovation and organizational effectiveness. More vertical structures (e.g., CEO to CIO to team leader to portfolio manager) tend to reduce the discretion of managers, lower the incentives to collect qualitative insight, and lead to more broadly diversified portfolios.2 What these firms achieve in terms of risk controls they can give up in terms of new ideas and conviction. Who are they? Many are private companies owned and managed by the investment professionals who founded them. By offering an ownership stake in the business, boutiques are able to attract some of the best investment talent in the industry while also ensuring that management’s interests are aligned with those of its investors. These firms tend to manage a small number of strategies and abide by clearly articulated investment processes, often developed by founding members. The simplicity of their organizations helps them respond quickly to changing markets, new opportunities, and imminent risks. Yet large asset managers have continued to consolidate their position in the industry. Through effective distribution and marketing efforts, the largest 5 mutual fund complexes—some managing more than $1 trillion in assets—today account for 40% of total industry net assets, according to data from the Investment Company Institute. The largest 25 complexes represent nearly three-quarters of total industry net assets.3 The countervailing model in asset management has been that of boutique managers employing specialized approaches. Whether they represent spin-offs from larger managers or have grown out of the hedge fund world, the population of boutique managers offering traditional ’40 Act funds has exploded in recent years. The boutique asset management structure can often result in high-conviction portfolios run by experienced managers who “eat their own cooking.” A list of the best-performing stock mutual funds of 2013 includes boutique managers in every category, with names such as RidgeWorth, Homestead, Thornburg, and Smead. Investors have taken notice. A 2011 study of the top 25 fastest-growing fund managers revealed that nearly half were boutiques with five or fewer funds in their lineups.5 Small in an increasingly crowded field Big and getting bigger Share of assets at the largest mutual fund complexes n 2000 Number of boutique mutual fund companies n 2011 700 70 600 60 500 400 40 300 30 200 20 100 10 0 2 n 2013 80% 50 n 2007 Largest 5 complexes Largest 10 complexes Largest 25 complexes 0 Offering 10 funds or fewer Offering 5 funds or fewer Source: ICI, Investment Company Fact Book, 2013. Source: Strategic Insight, 2013. 2 Massa, Zhang, The Role of Organizational Structure: Between Hierarchy and Specialization, 2010. 3ICI, Investment Company Fact Book, 2013. 4 Strategic Insight, 2013. 5 ThinkAdvisor, “Top 25 Fastest Growing Fund Managers,” 2012. Offering 1 fund March 2014 “John Hancock Investments’ managerof-managers approach is designed to marry the innovation, agility, and conviction of boutique managers with the oversight and risk controls of a large, institutional asset manager.” However, not every financial advisor or analyst is staffed to research and vet the staggering number of boutique managers that exists today. In fact, the organizational leanness that makes boutiques such agile investors is precisely what makes them so difficult for intermediaries to embrace. Niche asset managers generally have little in the way of wholesaling forces, marketing functions, and product management teams to help explain the process and philosophy of their funds to financial advisors. In fact, many lack the staffing and systems infrastructure needed to produce the kind of reporting that has become industry standard. A 2012 survey of boutique managers by State Street Research found that providing a high level of detailed and quality data to clients was the greatest data management challenge they faced.6 Small investment managers face other risks as well, including the enterprise risk of lawsuits (a relatively manageable event for a well-established asset manager), or the risk of a departing portfolio manager who is integral to the strategy. A different approach John Hancock Investments’ manager-of-managers approach is designed to marry the innovation, agility, and conviction of boutique managers with the oversight and risk controls of a large, institutional asset manager. Our structure as an independent and well-resourced investment advisor enables us to be forward thinking, to develop funds based on investor need, and then search the industry to find the portfolio management teams with the best skill set, track record, and experience to manage those funds. Our independence and experience as one of the longesttenured manager of managers enable us to achieve what we believe is an exceptional level of oversight. This experience, combined with the scale of our organization, greatly facilitates our research efforts, enabling us to meet directly with portfolio managers and other senior investment leadership at the firms with which we do—or are considering doing—business. 6 State Street Research, “Empowering Boutiques: The Rise of the Specialist Manager,” 2012. 7Simfund, Strategic Insight. Overall asset allocation rank based on target-risk and target-date assets, as of 8/30/13. Asset data as of 9/30/13. Includes all underlying JHF, JHF II, and JHF III funds; excludes funds in development and funds of funds. We believe our unique approach helps advisors and investment consultants in several key ways. First, our selection and oversight process provides an alternative for those who may otherwise rely too heavily on historical data to select and oversee investment managers. Second, our analysis provides a robust framework for understanding and managing portfolio risk. Third, we conduct the research of portfolio teams and processes that many advisors simply don’t have time for. An asset allocation mindset from the start One of the factors that makes John Hancock Investments different is our heritage as an investment manager specializing in asset allocation. We launched our asset allocation program in 1995 by developing portfolios for John Hancock’s retirement and insurance businesses. From the start, we employed an openarchitecture model, long before other fund complexes adopted the idea. In 2005, we launched our first asset allocation mutual fund for retail investors and maintained our commitment to the multimanager approach. Today, John Hancock Investments is the fourth-largest asset allocation provider in the industry, and the largest provider of target-risk portfolios.7 This asset allocation mindset leads us to a forward-looking process whereby we seek to identify strategies that can target emerging opportunities or help solve the needs arising in our multi-asset portfolios. It also affords us a unique perspective on how different portfolios and styles of management might behave within a broadly diversified portfolio. Ultimately, we believe this asset allocation mindset is to the advantage of advisors and their clients, who face real-world decisions every day about how to allocate strategies within a complete financial program. A core philosophy based on five pillars Through years of execution and refinement, we have developed a process for manager selection and oversight built upon five pillars. 1. Be a steward of capital Our manager selection and oversight process is wholly focused on helping shareholders achieve their long-term goals. To do so means building products and selecting investment strategies that make the most sense for investors—regardless of short-term marketability or sales growth potential. We recognize that investors have been shown to trade in and out of funds based on erratic or disappointing performance,8 so we focus on 8DALBAR, “Quantitative Analysis of Investor Behavior,” 2013. 3 managers who have a record of seeking consistent risk-adjusted returns over time and across market cycles. We also place strong emphasis on manager consistency—consistency in personnel and consistency in investment process. 2. Find the best managers, wherever they are We search the globe to identify potential investment management partners—from large international firms to boutique investment managers—who are the best at what they do. Once identified, our goal is to understand their investment style and how that style might respond in a variety of market environments and conditions. Each investment manager has a distinct style and will tend to be successful in a different market environment. In a typical year, we conduct approximately 350 in-person meetings with over 100 different investment firms to deepen our understanding of those firms and their investment processes. The unique diversity of our model, with proven specialists investing in each asset class, enables us to have the breadth of expertise across asset classes that eludes many traditional asset managers. 3. Establish a performance blueprint and hold each manager accountable In selecting investment managers, our goal is not simply to hire the best-performing manager within a particular asset class. Instead, we define an appropriate set of characteristics we call a performance blueprint, an objective, measurable framework for the patterns of risk and return we expect from a fund over the long term. A key part of crafting that performance blueprint is knowing what attributes matter most. For example, when we analyze an investment manager’s performance, we look at the underlying factors that have driven those returns, what sources of risk are present in the portfolio, and to what degree. We also examine how a portfolio’s composition has changed over time, and how the manager’s allocation decisions have affected performance in aggregate. These kinds of holdings- and returns-based attribution analyses help us gain deeper insight into the strengths and weaknesses of a particular manager, and to understand the factors driving overall performance. However, past performance—no matter how rigorously it is evaluated—is not a guarantee of future returns, and relying too heavily on backward-looking data will likely lead to overlooking some exceptionally talented managers. Similarly, if we rush to replace underperforming managers based on short-term performance, there is a good chance we will eliminate some long-term winners. In our efforts to add value for shareholders over the long term—and to avoid making critical hiring and firing mistakes— we conduct direct, in-person meetings with portfolio managers and seek to thoroughly understand the risks taken to achieve results. Face-to-face meetings with senior decision makers Asset allocation funds represent more than 50% of assets under management John Hancock Investments’ $111 billion in assets by fund type as of 12/31/13 2% Hybrid 2% U.S. small-cap equity 2% Muni bonds 3% High yield/bank loans 12% Target date 38% Target risk 2% Sector 2% Other fund of funds 1% Money market 29% U.S. large-cap equity 5% Multi-sector (FI) Other 50% 6% International developed (FI) 6% Intermediate (FI) 10% Closed end 17% Alternative 13% U.S. mid-cap equity 4 Source: John Hancock Investments. Includes all underlying JHF, JHF II, and JHF III funds; excludes funds in development and JHVIT funds. FI represents fixed income. March 2014 allow us to gain unique insight into whether we think past performance is repeatable. Specifically, we work to determine whether strong historical returns are simply a result of being in the right place at the right time or if there is something else in place—a superior philosophy, winning team dynamics, or a repeatable process—that will allow a particular manager to consistently add value over the long term. 4. Continually test our convictions Another critical component of our investment selection and oversight process is a robust level of debate and dialogue, which we use to test our convictions and ensure that we are making decisions in the best interest of shareholders. These ongoing discussions occur within our team, with other internal stakeholders, and with our asset management partners. We hold regular research meetings to analyze and debate current market events and their potential impact on the investment platform. We are also accountable to John Hancock Investments’ independent Board of Trustees, with routine meetings to discuss individual portfolios, fund performance, and new product offerings. In addition, we work closely with our compliance, legal, and fund administration teams to monitor the strength of internal controls at our partner firms and to ensure that investments fall within their guidelines. The result is a robust decision-making process with multiple senior leaders across the organization providing input and ensuring that we are making sound decisions for shareholders. A performance blueprint is an objective, measurable framework for the patterns of risk and return we expect from a fund over the long term. 5. U nderstand and mitigate the multiple drivers of portfolio risk We look at risk from a number of angles. From an investment perspective, our work is focused on examining the various characteristics of a portfolio to understand how it might behave in different scenarios. For example, we evaluate factor risk, such as momentum, by looking at investment styles to determine how a manager might perform in a particular market environment. We also evaluate concentration risk, looking at the average number of holdings in a portfolio in order to understand what we should expect in the way of volatility. We conduct stress tests of all portfolios, examining up to 30 scenarios to determine how each portfolio might react to changes in market environments. And we examine how our investment management partners use vehicles such as derivatives, structured products, and illiquid securities in their funds, as well as the efficiency with which they manage currency trading, cash, and collateral. Our real-time access to portfolio data across the lineup allows us to immediately analyze the impact of external events on the investment platform. If, for example, a natural disaster Global perspective drives better decisions In 2013, we held over 300 meetings with 150 firms in 5 countries and 16 states. Source: John Hancock Investments, as of 12/31/13. 5 Stress testing provides insight into potential vulnerabilities Scenario analysis examples Portfolio A Portfolio B Oil rises 30% 0.24 –0.08 S&P 500 Index declines 25% –3.96 5.77 VIX above 50% –1.01 1.74 European banks decline 20% –0.84 1.81 Interest rates rise 2% –0.46 0.20 the funds we offer always put the interests of shareholders first. The Committee’s primary mission is to: administer and oversee a comprehensive framework that facilitates the identification and management of risks that may affect our funds. monitor the activities of the funds’ advisors, subadvisors, transfer agents, and key service providers, as well as John Hancock Investments’ business operations that may affect the funds. serve as a channel of communication between each business unit function within the advisor. Source: John Hancock Investments, 2013. For illustrative purposes only. strikes a particular country or a company declares bankruptcy, we can quickly see which funds have the largest exposures and effectively gauge the impact. This quantitative insight is deepened by the constant qualitative interactions we have with a vast network of managers across the globe. We are also focused on understanding and evaluating noninvestment risk, such as operational and regulatory risks. To that end, our Risk and Investment Operations Committee, comprising senior representatives from the investment advisor as well as John Hancock Investments’ legal and compliance departments, meets regularly to ensure that the company and Liquidity analysis can identify risks at a security level Security 6 Days to liquidation % of portfolio Market value ($) COMPANY A 368,116 1.9294 17,211,063 COMPANY B 49,401 2.8094 25,060,741 COMPANY C 384 2.5215 22,492,419 COMPANY D 303 1.7167 15,313,762 COMPANY E 290 0.6673 5,952,620 COMPANY F 102 3.8169 34,047,431 COMPANY G 97 1.6748 14,939,900 COMPANY H 55 1.8808 16,777,220 COMPANY I 25 1.9366 17,275,123 COMPANY J 16 3.0207 26,945,506 Source: John Hancock Investments, 2013. For illustrative purposes only. Once identified, illiquid positions can be addressed and unwound as quickly as possible. March 2014 What makes a great investment manager? With over 11,000 registered investment advisors in the United States, average returns for groups of managers often mask a wide dispersion of results. Long-only active managers have two ways to beat a benchmark: by owning more of the winners or fewer of the losers. The potential for outperformance over any given period can be significant. However, the risk of disappointment, the difficulty in finding good managers, and cost are enough to send many investors the way of the index. Purely quantitative approaches to analyzing portfolio performance are, by necessity, backward looking. Even Morningstar’s expected utility framework does little to illuminate why a certain manager outperforms where others don’t. The key to effective manager research is determining whether a manager possesses the qualities necessary to make consistently good decisions over time. Ultimately, these characteristics come down to things like organization, culture, temperament, and experience. Only through meaningful discussion can one determine if a manager has what it takes to deliver repeatable results. Dispersion of active fund returns versus index returns Three years ended 12/31/13 n Range of active fund excess returns n Range of index fund excess returns 20% 10 0 –10 –20 –30 –40 Large growth Large blend Large value Mid growth Mid blend Mid value Small growth Small blend Small value World stock Intermediateterm bond Source: Morningstar, 2013. Universe of fund returns compared against benchmarks in the following categories: large growth (Russell 1000 Growth Index), large blend (Russell 1000 Value Index), large value (Russell 1000 Index), mid growth (Russell Midcap Growth Index), mid blend (Russell Midcap Index), mid value (Russell Midcap Value Index), small growth (Russell 2000 Growth Index), small blend (Russell 2000 Value Index), small value (Russell 2000 Value Index), world stock (MSCI World Index), intermediate-term bond (Barclays U.S. Aggregate Bond Index). It is not possible to invest directly in an index. Past performance does not guarantee future results. Results for investors At John Hancock Investments, we have worked to develop a process for manager selection and oversight that directly addresses what we think are some of the key challenges facing investment consultants and financial advisors: 1) an overreliance on quantitative data in selecting and replacing investment managers; 2) a lack of emphasis on understanding and managing risk; and 3) finding the time and resources to adequately analyze so many investment options. In particular, we believe our way of investing combines the innovation and nimbleness of today’s boutique manager with the controls and risk monitoring of the largest asset management institutions. The ultimate evidence of our success lies in the performance of our lineup, which is illustrated by our 34 four- and five-star Morningstar ratings, as of December 31, 2013. We believe this performance success across asset classes is the direct result of our unique investment approach and our commitment to putting the interests of our shareholders first. Our manager-of-managers model fosters independent thinking and high conviction across asset classes—attributes that have been key to the success of our funds. As markets evolve to reflect our dynamic global economy, we believe our unique approach will continue to serve investors in the months and years ahead. 7 The S&P 500 Index is an unmanaged index of 500 widely traded common stocks. The Russell 1000 Index is an unmanaged index of the 1,000 largest market-capitalization securities within the U.S. equity universe. The Russell 1000 Growth Index and Russell 1000 Value index represent the growth and value components, respectively, of the Russell 1000 Index. The Russell 2000 Index is an unmanaged index of the 2,000 smallest market-capitalization securities within the U.S. equity universe. The Russell 2000 Growth Index and Russell 2000 Value index represent the growth and value components, respectively, of the Russell 2000 Index. The MSCI World ex-USA IMI Index is an unmanaged index that captures large-, mid-, and small-cap representations across developed-market countries, excluding the United States. The Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including U.S. Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS. VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 Index options. It is not possible to invest directly in an index. Diversification does not guarantee a profit or ensure against a loss. Past performance does not guarantee future results. A fund’s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus contains this and other important information about the fund. To obtain a prospectus, contact your financial professional, call John Hancock Investments at 800-225-5291, or visit our website at jhinvestments.com. Please read the prospectus carefully before investing or sending money. John Hancock Funds, LLC Member FINRA, SIPC 601 Congress Street Boston, MA 02210-2805 800-225-5291 jhinvestments.com NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE. NOT INSURED BY ANY GOVERNMENT AGENCY. MF179616 MANAGERWP 3/14
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