There have been several times where we will write an article about a topic, and then follow up with three blog posts about the very same topic. The most recent article was about investment manager due diligence, specifically making qualitative analysis to describe the people, process, and philosophy of an investment product. These concepts are central to what leads an investment manager to make the choices they do. These are about the ideas that drive an investment product. They are about the “Why?” of an investment.
There is another level of due diligence that focuses on the application of those ideas – operational due diligence. Operational due diligence is about the “How?” of an investment product. How are illiquid assets being valued and verified? How is custody and trading managed? How are the traders who execute deals finding the best places to buy and sell large lots of stock, with the minimum of fees or maximum efficiency? Are the investments being sold to the public and managed according to legal compliance standards? In the event of a mistake, how are errors and omissions reported, insured, and managed? Is the product acting as a fiduciary?
Operational due diligence is generally more important for investment products for which conduct is less scrutinized and regulated, like Collective Investment Trusts (CITs) or illiquid alternative investments, some of which (i.e. Hedge Funds) are defined by their lack of regulatory oversight. It is in these dark places without standard accepted protocols of reporting and transparency where frauds, schemers, and rogue traders can act without oversight. There may be good reasons to invest in less regulated products in exotic asset classes or niche strategies, but you are then required to conduct additional levels of operational due diligence.