Giving money to an investment manager is not something done casually. It may be tempting to chase performance, but if you’re not careful you’ll give your client’s money to a manager who was merely lucky and is destined to underperform, or even worse, is a con artist like Bernie Madoff.
As a fiduciary, it’s your duty to conduct sufficient manager due diligence to reduce the probability of disastrous or disappointing outcomes. At the Asset Allocation for Private Clients conference held in Atlanta this October, Eric Bennett, CFA, chairman and CEO of Tolleson Private Wealth Management, gave his top 10 tips for manager due diligence before and during engagement. According to Bennett, following these guidelines could help you avoid some common manager-selection pitfalls.
10. Remember you are investing in people, not just performance.
Performance results are, by definition, backward looking, but hiring a manager is a business relationship like any other, and if you engage a manager of poor character, you will find your problems run much deeper than underperforming your benchmark. In good times and bad, integrity matters.
9. Have a well-defined process, and stick to it.
Develop your checklist for manager eligibility, and then stick with it. If you find yourself tempted to waive one of your requirements, examine the reason very closely. This might be an indication that you are responding emotionally to some attribute of the manager and should be a warning sign to you.
Finding managers with talent and integrity isn’t easy, so don’t rush. Don’t take shortcuts in your process to meet an arbitrary deadline, and don’t be rushed by the prospect of an oversubscribed fund. Consider if a small “seed allocation” might be an appropriate way to get to know your manager before making a full commitment.
7. Make sure the strategy has an opportunity set.
Innovative, alpha-generating strategies may not persist once word gets out. Convertible arbitrage, for example, worked well until the market wrung the inefficiencies out of the convertible bond market, but what was once alpha has become beta. Before making an allocation to a strategy, consider what might cause its ability to generate alpha to be short-lived.
6. Go see their office.
Never give money to a manager you haven’t visited. Is the business orderly and well run? Do the managers work well together or is there tension in the office? If something’s not right, you’re more likely to detect it with a visit.
5. Ask what percentage of their own money is invested in their strategy, and look for meaningful changes in partner capital over time.
All things equal, you want your managers to have “skin in the game,” so that their interests are as aligned as possible with yours. Are general partners pulling money out? If so, this doesn’t have to be a deal breaker, but the reasons should be thoroughly investigated.
4. Watch for strategy divergence.
If your fund has been 25% net long for three years and is suddenly 75% net long, you should ask for an explanation. If there are significant changes in the types of holdings, or changes in concentrations of certain sectors or asset classes, these are signs of strategy divergence, and you may not be getting what you expect from a manager.
3. Beware of growth in assets under management (AUM).
Strategies that work in small volumes may not be as successful on a larger scale, but a big change in AUM might also suggest the manager is disproportionately focused on asset gathering instead of investing. Also, beware of big sideline interests that might compete for your manager’s focus — the purchase of a NBA basketball team, for example. Distracted managers can become average very quickly.
2. Do a background and credit check.
An easy screen for potential red flags that you should do as a matter of course. A simple public documents search could save you major headaches down the road.
1. Understand what drives performance.
You’ve heard it before, but don’t chase performance! Most top-quartile managers will not hold their spots, and research suggests that a significant percentage will perform below the median in the future. Rather, examine track records closely and try to understand what is driving performance. Beware of concentrations in last year’s winners, and closely examine down periods, and outlier quarters and months. If you use manager performance as a window into understanding a manager’s analytical process, you’ll make better, long-term decisions and will be less likely to bolt a skilled manager experiencing temporary, short-term underperformance.
Bennett’s bonus tip: As long as human decision-making remains the core of investment management, you need to understand psychology in order to truly understand your fund managers.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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