and Investment Manager Due Diligence - Fi360

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Westminster Consulting Investment Manager Due Diligence As a fiduciary, the process of vetting, selecting and monitoring an investment manager is critically important. But how do professional investment consultants go about this process? When confronted by complex, deeply-technical questions posed by industry professionals, I usually turn to The Simpsons for guidance. Wait, did you say The Simpsons? I’m going to assume that most readers of this newsletter are familiar with the long-running animated series “The Simpsons”. There is the gullible patriarch - Homer Simpson, and his more perceptive daughter - Lisa. In this scene, Homer and Lisa are watching football on television, and Homer is holding a mail-pamphlet that says “Professor Pigskin”: Homer: “Doh! The Broncos won! Why didn’t I bet on them like Professor Pigskin told me to?” Lisa: “Who’s Professor Pigskin?" Homer: "He’s a pig who can predict football winners in advance." Lisa: "How is that possible?" Homer: "Because he’s got something no gambler’s ever had. A System! I’ve got this pamphlet four weeks in a row and every time the pick of the week has been right on the money." Lisa: "Ohhh. I get it. Every week they send out two pamphlets, half picking one team and half picking the other. Eventually, there’s a small group of people who only receive the correct predictions and think Professor Pigskin is always right. That’s when they ask for your money." It is too late by this point: Homer is already sending his credit card information to “Professor Pigskin” for insight into next week’s football game. Of course, Professor Pigskin is a scam, the pick Homer gets is wrong, and he loses a pile of money on a bad bet. I often consider the example of Professor Pigskin when conducting due diligence on investment managers. An investment manager typically uses a system to put together their portfolio. It can be a sound system, based on earnings quality, relative valuation, balance sheet strength, price momentum or any of a thousand – completely valid - reasons. But success, as we see from the example of Professor Pigskin, can easily come from an arbitrary system as well. Imagine for a moment that every investment manager operates on luck alone. Imagine their stock selection “process” is to simply throw darts at the Wall Street Journal and buy equal amounts of any stock hit by a dart. By luck, some managers are bound to outperform their peers. By definition, half of the investment managers are going to perform better than their peer group in any given time period. Given a large enough sample, some managers are assuredly going to outperform the index.
Westminster Consulting The point is performance data is insufficient to determine if a manager is good or bad. So, given this, how do you separate luck and random chance from good decision making? How do you know if you’re getting a “good” investment manager? Key to Investment Manager Due Diligence: Continuous monitoring of many attributes Again, just looking at the performance numbers is insufficient. The best managers periodically underperform and overperform their index. The “batting average” – the percentage of time that a manager outperforms their benchmark - for the best investment managers is only around 60%. In other words, the very best managers have historically underperformed their benchmark 40% of the time, often for a number of years. In addition, the timing of the investment manager screening can have a large impact on the final selection. Example: The ABC fund is an aggressive, high-risk, high-conviction mutual fund that makes large bets on individual stocks and sectors. Sometimes, the large bets pay off handsomely. Sometimes, the large bets are completely misplaced and the fund drastically underperforms. When measured last quarter, the volatility of the fund was high, and long term relative performance was below both peers and the index. Manager ABC has suffered tremendous fund outflows and has decided on a desperate and risky bet towards a handful of high-risk stocks. They got lucky and, this quarter, their bet paid off. The few stocks selected by ABC sharply outperformed the market. In fact, outperformance was so high in this concentrated portfolio that the product’s long term annualized averages now outpaces peers and the benchmark. An unsophisticated investor – looking at long term risk and long term reward numbers alone – may have an inaccurate assessment of the fund. The unsophisticated investor acknowledges that the fund has high risk, but haven’t long term investors been compensated by advantageous long term returns? This example supports the case for a broad variety of screening criteria. For instance, an industry leading mutual fund screening tool sorts funds against a variety of quantitative attributes (long term performance relative to peers, risk relative to peers, and so on). In this case, the ABC fund may have high risk and return, but the risk-adjusted return metrics may still be poor relative to peers. This tool may also register the change to the portfolio (proportion of allowable assets, consistency of peer group / category). Looking at the fund’s net inflows will verify if enough long term investors really have been compensated for the risk, or if the fund’s small size implies a lack of stability. Furthermore, this example suggests the value of continuous screening over time. This tool makes these measurements continuously (every quarter, in this instance). The ABC fund may get a better score from the tool, due to the tremendous outperformance, for this quarter. However, the database keeps track of the previous quarters where the timing was not favorable to the ABC fund. By using long-term averages in scoring methodology, a consultant can get a better sense of the consistency of relative performance.
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