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.
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.
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 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.”
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.