Procedures for selecting and monitoring QDIAs

Second of two parts
Part one (InvestmentNews, June 4) introduced the provisions for the new qualified default investment alternative safe harbor and the procedures an investment adviser should follow in evaluating a QDIA.
This column will outline the procedures for selecting and monitoring a QDIA.
Plan sponsors have a fiduciary duty to demonstrate that the plan’s investment options, including QDIAs, have been prudently selected and monitored. QDIAs present unique and complex challenges to the plan sponsor, and so, undoubtedly, sponsors will turn to investment advisers for help.
I think selection due diligence procedures and monitoring criteria should be mirror images of one another — if manager tenure is part of the search due diligence, then manager turnover should be an important monitoring criterion. Therefore, the same procedures should apply for both the selection and monitoring of QDIAs.
An investment adviser could approach the analysis of a QDIA in two ways. The first approach is to compare the overall performance of a QDIA with an appropriate peer group — comparing a target maturity fund with other target maturity funds of the same time horizon.
The second approach — and the one that I think is more appropriate — is to look at the overall performance of the QDIA, compared with that of its peer group, but then take the QDIA apart and compare each asset class investment strategy with its peer group’s. This approach obviously involves more work, but it will help to detect flaws in a QDIA long before the flaws are reflected in the QDIA’s performance.
The following breakdown shows thresholds for various aspects of due diligence — under the traditional process and for QDIAs. This particular traditional due diligence process is one that I have used for more than eight years, and it is the basis for the fi360 Fiduciary Score that is used to analyze all 16,000 funds in Chicago-based Morningstar Inc.’s universe.
Minimum track record:
Traditional: Each investment option should have at least a three-year history.
QDIA: The average history for each underlying asset class investment strategy should be at least three years.
Stability of organization:
Traditional: The same portfolio management team should be in place for at least two years.
QDIA: The average tenure of the team for each underlying asset class investment strategy should be at least two years.
Assets in the product:
Traditional: The investment option should have at least $75 million under management (including assets in related share classes).
QDIA: The average underlying asset class investment strategy should have at least $75 million (this can include assets in other funds with the same strategy).
Holdings consistent with style:
Traditional: At least 80% of the underlying securities should be consistent with the broad asset class.
QDIA: Allocations to both equities and fixed income should be evaluated against the peer group — highest allocation to lowest — with the screening threshold set at the bottom quartile for equities and at the peer group median for fixed income.
Correlation to style or peer group:
Traditional: Each investment option should be highly correlated to the asset class being implemented.
QDIA: The number of asset classes that make up the QDIA should be evaluated against the peer group — most asset classes to least — the screening threshold being set at the peer group median.
Expense ratios/fees:
Traditional: Fees shouldn’t be in the bottom quartile (most expensive) of the peer group.
QDIA: The wrapper expense, and that of each underlying asset class investment strategy, should be evaluated, separately, against the peer group — cheapest to most expensive — the screening threshold being set at the bottom quartile.
Performance relative to assumed risk:
Traditional: Risk-adjusted performance should be evaluated against the peer group median manager’s risk-adjusted performance.
QDIA: The risk-adjusted performance (alpha and/or Sharpe ratio) of the QDIA and that of each underlying asset class investment strategy should be evaluated, separately, against the peer group’s median.
Performance relative to a peer group:
Traditional: Each investment option’s performance should be evaluated against the peer group’s median manager return, for one-, three-, and five-year cumulative periods.
QDIA: The one-, three-, and five-year performance of the QDIA and each asset class investment strategy should be evaluated, separately, against the peer group’s median.
There are industry professionals who think that another factor that should be considered when evaluating a QDIA is whether the underlying asset classes are implemented with in-house investment managers or with an “open architecture” platform. I think the above due diligence approach levels the analysis so that this becomes a moot point.
It will readily become apparent if a financial services firm that offers a QDIA is constructing the fund with inappropriate or untested investment managers and strategies or is overcharging for investment management expenses.
The complex approach described above inevitably will favor QDIAs constructed from investment strategies that are covered by readily available data sources. The investment adviser’s analysis also should be conducted on a quarterly basis.
There are investment advisers who view the introduction of QDIAs as a threat to their practice — that the QDIA represents a “set it and forget it” investment option for the plan sponsor that diminishes the adviser’s importance. I disagree, because the fiduciary evaluation, selection and monitoring of a QDIA is a very complex process that requires the skills of a trained investment adviser.
Donald B. Trone is president of the Center for Fiduciary Studies and chief executive of Fiduciary360 LP, both in Sewickley, Pa.