January 6, 2009
While there are times when investors fall hopelessly in love with a management firm with a particularly hot group of investment vehicles, more often such affection is reserved for star portfolio managers, not their firms. Both must be assessed, but a detailed analysis of the firm will probably prove more productive. Its strengths and weaknesses, and those of its leaders, are likely to have a greater impact than most investors imagine. The incentives in place for members of the firm should mirror the needs of investors, potential conflicts of interest should be minimal and well understood, and the firm’s decision-making processes and staffing model should work in a variety of market environments.
As for those star portfolio managers, advisors can easily fall into the trap of identifying too closely with them at the expense of objectivity. Opportunities to be on calls with managers or interact with them at conferences should be used to gather valuable insight about how they do what they do. Unfortunately, many of those interactions often amount to little more than a recitation of the current economic and investment ideas of the manager. The advisor gets the sense that he knows the manager better, but little of lasting value is learned. Instead, face time should be spent grilling the manager with hard questions about investment process.
Understanding is, after all, the goal of due diligence, which makes doing it from a distance so hard. At its core is a search for anomalies that need to be explained and questions that need to be asked. Having the opportunity to get those questions answered is an important part of gaining the comfort needed to say that a manager has a reasonable shot at producing the elusive alpha that an advisor wants to deliver to her clients.
Faced with the difficulty of analyzing managers themselves, advisors must decide whether to outsource that function by counting on intermediaries to analyze the managers under consideration. Relying on another firm to generate the evaluations can provide needed leverage for advisors, especially sole proprietors, but countless examples point to the risks in such an approach. (Think of how the reliance on the credit rating agencies led to failed investment strategies throughout the industry.) At a minimum, advisors need to understand thoroughly what drives third-party evaluations and under what conditions their processes are likely to break down.
Ultimately, doing due diligence, whether in person or at a distance, is about knowing what you know and what you don’t. Do you have enough information to properly appraise the chance of an investment manager filling its designated role? If not, continue the process or select a passive alternative for now. As in a game of cards, it only pays to play when you’ve identified a clear advantage.
Tom Brakke, CFA, writes and consults about how investment decisions are made. His online writings are found at researchpuzzle.com.
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