Investment Due Diligence

Due Diligence

When hiring external managers, one needs to judge whether the observed performance is coming from skill or luck. As I explain in the section on “Investment Skill measurement”, it is very difficult to distinguish between a skilled and a no-skilled manager. With an IR of 0.50, it would take at least 16 years to confirm that the value added is not from luck. Thus we need to complement our quantitative analysis with a qualitative one. There is no guarantee that a due diligence exercise will provide significant value added. In fact, choosing outperforming managers is a little bit like choosing outperforming stocks and bonds. One’s IC (a measure of one’s investment skill) at choosing managers is probably not significantly greater that what we observe in stocks, bonds, TAA and other investments which are also chosen based on both quantitative and qualitative factors.

In all asset classes, we generally (always) hire experts in the field to pick and choose outperforming stocks and bonds: an expert in banks to pick bank stocks, an expert in energy to pick energy stocks. Why is it that fund of funds generally hire young generalists to pick and choose outperforming managers? The best business model that I have seen was a Fund of Funds who sought to hire experienced hedge fund specialists in various hedge fund strategies – i.e. people who had managed hedge fund themselves and who had a deep understanding of some hedge fund strategies. Some great investment organizations have great marketers who can convince about anyone. They can’t fool an expert in the field though.

Due Diligence questionnaire/Report

There are many detailed sample questionnaire available on the net (including AIMA), some very lengthy. They often serve more to protect the Fund of Funds’ manager in case of a bad investments. “I did my due diligence and here is the proof – the hedge fund must have hidden some important information”.

Proper due diligence includes:

• Detailed information of the investment manager including ownership, experience, location, organization.
• Detail about the investment strategy and its source of alpha – including detailed historical performance attribution. Target alpha.
• Detail about the risk controls and the portfolio construction – ideally a portfolio construction which integrates market risk controls. Target leverage and risk.
• Detail about execution and trading ideally with measures of the quality of implementation including trading costs.
• Detail about the liquidity of the assets, the capacity of the strategy and the withdrawal constraints.
• Expected Beta and correlation with standard asset classes (equity and bonds) and explanations if these are significantly different from zero (for hedge fund) or one (for long only portfolios). Explanations of why one would pay performance fees on the beta part of returns for hedge funds.

Experience

While the above analysis is important, the most valuable aspect of due diligence is the review by an experienced investment manager. And a review needs to be done onsite. When I mentioned this to the investment committee of a local University pension plan, they were surprised and ask for a confirmation. I think they were worried about the increased cost of onsite visits. Yet the same organization had invested in one of the fraudulent fund mentioned below. Marketers are great people but they make their living on selling you their products, whether good or bad. I prefer to see the operations, talk to the portfolio managers, and see their workplace and systems. You can detect a lot of good or bad things in doing so – independent of how rosy the marketing pitch is.

Here are some of the dangers I came across in performing due diligence on investment managers:

1. Manager's Selection: Survivors always look better, whether they are skilled or not
2. What you say you do is not what you do!
3. S&P STAR system with low IC
4. Hedge Fund FRAUD
5. Spurious Models
6. Improper Computer Systems (Software)
7. Wrong Backtesting – Data Mining
8. No Performance Attribution of an Investment Strategy with a Judgmental Overlay
9. Improper portfolio construction neutralizing a manager’s alpha!
10. A bond firm fits an over-parameterized model. Value added not from what the manager says.
11. Improper asymmetric risk controls
12. Improper implementation monitoring
13. Few bets / concentrated themes and improper risk monitoring
14. Hedge Fund lack of risk controls & Beta
15. Marketing/Story telling organization vs Knowledge-based organization
16. What you say you do is not what you do!

For more information on due diligence, please contact us.

Dominic Clermont, ASA, MBA, CFA