Today’s emphases on fiduciary responsibility, risk management and increased transparency require better due diligence when selecting managers. Especially in today’s turbulent markets, advisors who spend more time and resources to do due diligence well can find themselves at a distinct competitive advantage.
While these tips won’t necessarily help you identify the next active management superstar, they can bolster your manager selection and due diligence program:
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Solidify your core. Scott Welch, Senior Managing Director of Investment Research and Strategy at Fortigent, LLC, a Rockville, Maryland provider of outsourced wealth management solutions, advocates the rigorous due diligence that moves beyond past performance to look forward. His process is named “SMART2,” and it addresses the following topics:
- Strategy: What is the fund’s philosophy? How do the fund’s objectives and strategic strengths rate both in isolation and relative to peers? Is the fund’s strategy intuitive, implementable, and repeatable? How viable is the strategy given existing market conditions and economic factors?
- Structure: What is the fund’s legal structure? How liquid is the fund? Will the fund be forced to sell key holdings if it faces unforeseen redemptions?
- Management: What is the management team's previous experience and tenure together? What is the depth of the fund’s organizational infrastructure?
- Methodology: What is the fund’s decision-making process? Consider all elements of it, including idea generation, hypothesis testing, modeling, execution, and monitoring.
- Asset Allocation: How robust is its asset allocation process, and does it create true added value? Is there a meaningful quantitative aspect to it? How are reallocation and rebalancing decisions made?
- Assets under Management: Does the fund have sufficient assets under management to execute its strategy successfully? Has it reached critical mass to secure business viability? Have assets grown too much or too quickly?
- Risk Management: How does the fund analyze and manage risk? What are the quantitative and qualitative metrics it employs? Is the process disciplined? Is there adequate transparency? Is there separation between the portfolio and risk management functions within the fund?
- Research: Is the fund’s research superior to peers’? Does it give the fund an informational edge? Is the depth of the research team adequate, and is there meaningful use of qualitative and quantitative analysis?
- Track Record: What are the risk-adjusted returns, alpha generation, and the volatility of returns? How do positive and negative months compare? What was the worst drawdown and time of recovery? How has the fund performed both absolutely and relative to peers? Under what market conditions should the fund perform best / worst?
- Tax Efficiency: Is the fund’s strategy tax efficient? Are historical after-fee, after-tax returns compelling?
“In today’s transitioning market, advisors need transparency into the manager’s positions, trading strategy, books and records,” Welch says. “Specifically, advisors should seek a greater understanding of return drivers by asking: Are the returns of a fund consistent with what the stated strategy should generate? What is the degree to which leverage (or lack thereof) drives returns? How, and how often, is the portfolio priced?”
A volatile market also makes it essential for advisors to explore the liquidity profile of funds. Welch explains: “Managers should provide regular liquidity reports – how much is available at any given point in time as well as information on the concentration of investors within the fund – to help advisors determine how one large redemption request might affect remaining investors.”