Rethinking Due Diligence and Manager Selection

Which criteria are truly relevant to your clients when selecting investment managers and which are not?

The portfolio manager and blogger Tom Brakke, CFA, says that due diligence in manager selection has become far too much of a standardized documentation process for advisers.

Instead it should be an investigative discovery process focusing on the defining characteristics of the investment management organizations where the managers work. In the long run, organizational structure — not past performance — is likely to drive future performance.

In this question-and-answer session following Brakke’s presentation, he considers manager diversity, self-awareness, the active vs. passive debate, alternatives, and platforms.

A full version of this presentation is also available in the CFA Institute Conference Proceedings Quarterly.

Audience member: Based on your experience, is there one characteristic that has the most impact on a person becoming a high-quality manager? If so, is it education, credentials, age, gender, experience, or something else?

Tom Brakke, CFA: I do not want a hired asset management firm to be one dimensional at all, so the diversity element comes into play. I want cognitive diversity, not just social diversity. Many management firms, especially small firms with managers who have gone out on their own from a successful organization, are too monolithic in terms of how they think about the world. They might do okay for a while, but they are going to have trouble in a variety of different environments.

I recently asked a number of investment firms about their training processes, and you might be surprised that 90% to 95% of them said they essentially have no training and development plans for senior investment staff. Apparently, portfolio managers come fully formed! They do not have anything they need to work on.

If you could pose only one question to an asset manager, what would it be?

My first question would be: What are your weaknesses? I really want to understand what managers have identified as areas in which they have to improve for the organization to be successful. I know from experience that all I am going to hear back are positives, strengths. Most managers will squirm if they are asked that question because they do not want to talk about weaknesses. They do not want to admit that there is something that they are not as good at as others.

Girard Miller, who is the chief investment officer for the Orange County Employees Retirement System, recently created a very interesting request for proposal. He provided seven characteristics that a firm ought to have, and he told candidates to list them, one through seven, in terms of how good they were at each — a forced ranking. Of course, they could still claim they were good at all of them, but he forced them to rank each.

I want the candidates to tell me what they need to work on and how they are going to improve.

Given the work involved in doing proper due diligence, and given the underperformance of active managers, is it better just to throw in the towel and go passive?

I do not know if I would say “throw in the towel,” but I think it is better in many cases to at least have part of your exposure be to passive investing, if only to be able to get the exposure to beta. Passive management has problems just as every other approach has. That said, in terms of weighing one against the other, organizations have to be honest with themselves about whether they are going to add value. The evidence is all clear: The beneficiaries of active management are the active management firms themselves. They really do add value before fees, but not after fees. Then, you add to that a layer of advisory fees, and the client is not served at all.

The question of active versus passive is worth asking. If you can improve your client’s situation by using some passive strategies and concentrate your active strategies into areas in which you actually know something more than other people — that is a pretty powerful combination.

Is the process more difficult for certain asset classes? Are there due diligence analysts that have certain characteristics? Maybe they specialize in a certain class?

Much research is devoted to what is commonly called “operational due diligence” for hedge funds and the like. I think some of that same intensity ought to be brought to analyzing long-only managers. Many managers of alternative investments are quite opaque, even in the liquid alternatives space. So, you have to ask questions about levers needed to operate in a particular strategy.

Alternatives have become very popular, but the knowledge base is lagging pretty dramatically. If I gave a test to most advisers about what is in those products and how the products should be expected to perform over time, my guess is that most would fail. As a wealth management organization, if you are using alternative products, I recommend you pay a lot of attention to them and make sure, from an education standpoint and from a due diligence standpoint, that you are prepared to make good decisions on behalf of your clients.

One way to select managers is to use pre-vetted managers and products on custody platforms. Are these platforms performing the same level of due diligence when they accept a manager on their platforms?

Most are doing some due diligence, but from what I have seen, it has not been thorough. In many cases, the effort is much more oriented to getting good performing managers into the system than understanding the managers in depth.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image courtesy of W. Scott Mitchell