January 6, 2009
The Bernard Madoff scheme is widely recognized as revealing a failure of due diligence; the investors, intermediaries, and regulatory authorities who were burned did not spot red flags that others saw. Now, in the wake of the fraud, advisors and their clients are rethinking their processes and standards when it comes to researching all types of money managers.
In-depth due diligence is time consuming, expensive, and essential. Thankfully, advisors analyzing mutual funds and managed accounts generally have little trouble investigating operational issues, at least compared to those evaluating hedge funds, venture capital, and other alternative asset classes. Complacency is never warranted, of course, but for most firms used by advisors it is relatively easy to determine whether the basic structure of their operations meets appropriate standards. If not, caution is in order.
Once an operational review is complete, advisors must determine the likelihood that a particular manager will produce “good” performance going forward. (For the purposes of this article, we will set aside discussion of what constitutes “good” performance, since the principles addressed here apply regardless.) The rub for most advisors is that due diligence typically must be done “from a distance,” and is consequently less likely to add value than would be the case if greater access to the manager were possible.
In evaluating investment managers, consultants commonly look to the “The Four Ps”: philosophy, people, process, and performance. Unfortunately, throughout the industry past performance is weighted too heavily and is a more dominant factor in practice than industry participants admit. Advisors share this tendency with institutional and individual investors, but the lack of detailed information about other manager attributes compounds the problem, meaning they rely even more on past performance when making choices.
None of this is to say that performance history is not important, but evaluating performance well is a complex task, as other Advisor Perspectives articles have explored in great detail. [Ed. Note: For example, see Mining for Factors that Predict Mutual Fund Success, Collective Wisdom, Financial Markets, and Investment Lessons from Google™, and Luck versus Skill in Active Mutual Funds.] Simple comparisons and measures often obscure important aspects of a manager’s performance, so the due diligence process must include a detailed deconstruction of returns and holdings and an interpretation of what any patterns found indicate. Furthermore, given the wide range of fees charged on packaged products, an analysis of whether incremental costs are likely to yield extra returns on a sustainable basis is needed.
Analyses of active managers undertaken without the relative luxury of on-site visits should be aimed at estimating the probability that a manager will outperform an appropriately matched passive strategy. Given that key pieces of information may be lacking and that the chances of finding a manager that will consistently outperform an index are relatively low, the “hurdle rate” for choosing an active manager on the sole basis of analyzing returns should be high.
The real value of being able to quiz investment managers directly (more on that later) is to judge the interplay between performance and the other Ps – philosophy, people, and process. In the case of Madoff, neither his compound rate of return nor its volatility made sense given the stated strategy or the organization that was in place. Despite the unusual nature of this case, it illustrates that investors tend to prize repeatability and long-term performance without regard to the methods that produced it. With Madoff, even the incongruence of his steady performance and the changing market environment failed to give some investors pause. Those that asked Madoff or his marketing agents the hard questions about these discrepancies stayed away when they couldn’t be answered.Display article as PDF for printing.
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