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TRANSCRIPT
Improving Due Diligence
and Manager Selection
Tom Brakke, CFAtjb research
CFA Society Cleveland
October 17, 2017
@researchpuzzler @CFACleveland
Four (overlapping)
sources of
information
Onsite visits
Due diligence from a distance
In-house manager research resources
Third-party research firm reports
Ways to categorize
asset management
firms
Asset managers vs. asset gatherers
True organizations vs. collectives
Home-grown vs. rolled-up
Learning vs. defensive cultures
Keys to success
for professional
services firms
Source:
What It Takes
Charles Ellis
Mission
Culture
Recruiting
Developing people
Client focus
Innovation
Leadership
Consider the whole
organization
Source:
Focus Consulting
OperationsInvestment
Distribution
Consider the whole
organization
Business
OperationsInvestment
Distribution
OperationsInvestment
Distribution
The typical target
Business
Investment
Distribution
Operations
Intersection:
✓ Asset gathering
versus asset
management
✓ The narrative
versus the reality
Business
OperationsInvestment
Distribution
Intersection:
✓ Information
infrastructure
✓ Compliance
✓ Position
valuations
✓ Cultural hints
(power imbalance)
Business
OperationsInvestment
Distribution
Intersection:
✓ Accuracy of the
information used to
market the strategy
✓ Capacity and
capability issues
Business
OperationsInvestment
Distribution
Take a holistic view
of the organization
and the purpose of
due diligence
Business
Looking for
differentiation Same as Different than
Goals
creating the narrative
cracking the narrative
Common problems
with due diligence
practices
Not enough skepticism
Uncracked narratives
Too little time spent
Too narrow of an approach
Too few people encountered
Poor interview processes
Untrained and inexperienced analysts
My “index card”
for an onsite due
diligence visit
One-on-one meetings with many people
My agenda, not theirs
No presentations or pitchbooks
Follow the script, but don’t follow it
Triangulate
Remember: everything is connected
Some questions
that reveal
“What are the areas in which your
organization needs to improve?”
“Why is your investment team structured
the way it is?”
“When do you plan to outperform and
when do you plan to underperform?”
“For [a given idea], what was the ‘how’ of
it and who, specifically, was involved in
each phase of decision making?”
“What differentiates you?”
Looking for ways in Organizational design and beliefs
Changing investment roles
Behavioral nudges and guardrails
Academic research
Forecasting
Valuation
Technical analysis
A plethora of Ps Philosophy
People
Process
Performance
Portfolio
Parent
Partnership
Products
Purpose
Passion
Perspective
Progress
Price (or Phees)
People Not bios, not combined years
“Really smart” is really off track
Culture: perceived vs. real vs. required
Leadership and development?
Personal and organizational behavior?
Team composition and understanding?
Source: Five Eyes
The shape of
returns
Process The marketing version is not the process
Structure and process are related
“Consistent and repeatable” loses the game
Stresses change the process
Process The marketing version is not the process
Structure and process are related
“Consistent and repeatable” loses the game
Stresses change the process
We see performance and infer process
A plethora of Ps Philosophy
People
Process
Performance
Portfolio
Parent
Partnership
Products
Purpose
Passion
Perspective
Progress
Price (or Phees)
A plethora of Ps Philosophy
People
Process
Performance
Portfolio
Parent
Partnership
Products
Purpose
Passion
Perspective
Progress
Price (or Phees)
A performance
equation
Source:
Jacques Lussier
Ipsol Capital
Beta (market exposure)
+
Factor exposures
+
Alpha (skill)
+
Luck (noise)
=
Returns
Short-term
performance (and
manager types)
Concept:
Grinold and Kahn Doomed Forlorn
Blessed
Lucky
Skilled
Insufferable
Long-term
performance
(assumed)
Concept:
Kevin Burrows
Lucky
Skilled
Performance
evaluation
problems
One path of history, one stream of data
Lack of predictive ability
Rankings are often misleading
Attribution methods are imprecise
Evaluation windows are too short
Metrics (like Sharpe ratio) are overused
Performance
evaluation
problems
One path of history, one stream of data
Lack of predictive ability
Rankings are often misleading
Attribution methods are imprecise
Evaluation windows are too short
Metrics (like Sharpe ratio) are overused
Bottom line: Performance is for questions, not answers.
Business risk,
career risk, and
choices
Quotes:
Jason Hsu
“Would a consultant or financial advisor
recommend a shortlist of managers with
poor recent performance?”
“Would the pension CIO and his staff
choose a manager with a negative
trailing three-year alpha to present to
their layman board?”
“Would salespeople and marketers
educate client prospects on products that
have recently underperformed?”
The behavioral cycle
Source: Manager Selection, Scott Stewart
Hire Hire Hire
Etc.
FireFire
What they say What we think What we say
What they say What we think What we say
~95%
THEIR
NARRATIVE
Preferences 1) Boutique organizations are preferred
because they focus on a small number of
strategies and have better alignment with
our interests.
2) Large firms are preferred because they
have more resources and greater stability
to bring to bear on the investing
challenge.
3) It depends.
Preferences 1) A chief investment officer should also
run a portfolio, to improve his or her
understanding of the dynamics of the
market.
2) A chief investment officer should be
focused on building the organization so it
can perform well, not worrying about a
managing a portfolio.
3) It depends.
Preferences 1) In a large firm, a centralized
investment research function is preferred
because it allows for deep specialization
across a range of investable vehicles.
2) Distributed research, in which analysts
work directly for portfolio teams, is better
because the analysts are more
responsive to the needs at hand.
3) It depends.
A starting point Things we seek Things we avoid
A starting point
(incomplete
example)
Things we seek
Be countercyclical
Use time arbitrage
Independent firms
Real teams
PM ownership
Tracking error
Things we avoid
Large and popular
CIOs who are PMs
AUM incentives
IPO-driven results
Window dressing
Bluster
Manager selection
using multiple
criteria
Decision
yAttributes
?
Recommendations Tailor your approach to your situation
Admit what you don’t know
Stress organizations over investments
Get specific about beliefs and preferences
Design out performance chasing
Restructure your decision processes
Behave differently to succeed
