and Investment Manager Due Diligence - Fi360

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Westminster Consulting Key to Investment Manager Due Diligence: Understanding Style Another example: Imagine that you are a 401(k) plan sponsor during the 2008 financial crisis. The stock markets are being sorely damaged by the financial crisis, and your current investment manager – Mutual fund AGG - cannot even keep up with the very low benchmark. You decide to get a replacement. You conduct an investment manager search and find Mutual Fund DEF has had fantastic relative performance in both the short term and long term. You hire Manager DEF in early 2009 and hope for the best. The markets start to improve, but Manager DEF continually underperforms the market for several years. What happened? In this case, the plan sponsor simply may not realize that Manager DEF is following a defensive strategy: a strategy that tends to protect money in down markets, but fall behind the market in optimistic, upward moving markets. Worse, you may have left mutual fund AGG – an aggressive high-beta fund – at precisely the wrong time. As a high-beta fund, Mutual Fund AGG started to significantly outperform once the markets improved. This sort of thing happens all the time. A manager is hired because his style is in favor, but when the market favors a different style, relative performance suffers. The adage used in finance circles is: “don’t chase the hot dot”. In other words, do not select investments – a manager, an investment style, or even an asset class - solely because it is the greatest outperformer at the moment. Again, we are looking for a “good” investment manager, but that means different things to different clients. For instance, Mutual fund DEF will tend to outperform the market in down years and underperform the market in up years. Despite the current underperformance, that style of manager may be very attractive for conservative investors. On the other hand, a different client may prefer an all-weather fund with roughly constant opportunity to outperform, or underperform, in any market. The ultimate goal is to match the underlying style of manager to the preferences of the client. Understanding the manager’s style, and your client’s preferences, is clearly required. Key to Investment Manager Due Diligence: Qualitative Assessment Much of the conversation has focused on the measureable quantitative results. Savvy investment consultants should also ask the investment manager: How did you make those decisions? Who are the people making those decisions? What process did you use to make that selection? What’s the overall philosophy of the product? In other words, understanding a product requires qualitative research. Why is this important? Obviously, it will help an investment manager create an entire set of investments that complement each other. For instance, an endowment client may prefer to invest in a combination of passively managed and actively managed funds to reduce fees, hedge manager risk and maintain the possibility of alpha (risk adjusted returns in excess of the benchmark). Alternatively, a change in the underlying process can signal an improvement, or a genuine shortcoming in the product. For example: Fund XYZ is a stalwart institutional fund that credits its
Westminster Consulting long term track record on their deep fundamental research on each underlying stock selection. Let’s say that the manager recently made an investment in Stock Q. Unfortunately, Stock Q has just been accused of misreporting their financial data. As a result, Stock Q takes a beating in the market, and the manager underperforms. Again – even the best managers will underperform the markets periodically. Good research can minimize errors and possibly catch frauds, but even the best investment managers make mistakes (or simply get unlucky). The key to assessing the investment manager is their reaction to this scandal. Manager XYZ, in light of the allegedly fraudulent data, would be expected to increase their scrutiny of Stock Q, dive deeper into their financial records, ask questions, and double-check their presumptions. Manager XYZ did none of these things. Instead, Manager XYZ stands on its previous analysis – based on potentially flawed data. In fact, Manager XYZ buys even more of Stock Q in an attempt to buy a stock that is out-of-favor and potentially a bargain. Manager XYZ reasons that the market is overreacting to the scandal, and notes that similar accounting scandals resulted, initially, in deep setbacks for a stock, but that strong recoveries happened once the extent of the fraud was clarified and accounted for. Let’s be clear: Manager XYZ’s analysis may be completely correct. The market might be overreacting. Stock Q might be a bargain now. The “double-down” on Stock Q might being an extremely profitable decision. However, the decision was made without any of the fundamental research that the manager is recognized for. The re-buy decision was an educated guess, and that is not how their stock selection process has been advertised to investors. This example – except for the names - is essentially true. In real-life, Stock Q’s troubles went deeper than previously assumed. Several members of the board were accused of misleading investors. Stock Q trading has been suspended for months as regulators try to sift through the information and determine the truth. Without a market, the price of Stock Q has plummeted. In real-life, Manager XYZ experienced high outflows, due in part to poor performance but also due – we suspect - to the disappointment of investors who expected a level of due diligence from the manager that they did not receive. In a separate, but related, story, a large hedge fund has recently been sued for owning a substantial amount of Stock Q. The suit charges “reckless indifference” and “failure to conduct the required proper due diligence [...] amounts to gross negligence and breach of the defendant’s fiduciary duties.” In Conclusion There are no guarantees in investments. However, making well-reasoned, prudent decisions based on good data is something every investor should strive for. Moreover, as a fiduciary, it is a responsibility to have a manager selection process and to document it. A clear understanding of your investment managers and an expectation of how they operate in different market environments will improve the chances of selecting a manager that best meets your needs. In the long term, this understanding should promote the better outcomes.
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