Bill Hornbarger on Due Diligence | Moneta

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By Bill Hornbarger, Chief Investment Analyst, Moneta Group

One of the most interesting and enjoyable aspects of the Moneta Investment Department’s job is managing due diligence. Through November, our team is on track to have meaningful meetings with approximately 250 asset managers in calendar year 2013. We define a “meaningful meeting” as one that includes a portfolio manager, analyst or a product/portfolio specialist that can provide material or relevant insight into the strategy’s process, philosophy or performance. Having a cup of coffee with a member of the distribution team is not included in the category of meaningful meetings. In fact, it might surprise many to learn that for every scheduled meeting, there are multiple opportunities that we decline for a variety of reasons. 

While those meaningful meetings are tremendous learning opportunities and the conversations are broad-ranging, the due diligence process is actually constant, ongoing and even somewhat evolutionary. Earlier this year, we added a new small-cap growth manager that we first met with almost four years ago and first visited in mid-2012. Over that time frame we tracked their performance and the growth of their assets under management and decided to add them after a need was identified. We then completed the necessary steps (including more meetings with the portfolio team and an additional onsite visit) to feel comfortable enough to add them to our recommended list. 

Specifically, there are three steps that we go through in the due-diligence process. These steps are quantitative screening, qualitative review and ongoing monitoring. Every manager we consider is subject to all three steps, and many managers are eliminated from consideration along the way. 

Quantitative Screening

Quantitative screening is a relatively simple and mechanical process that narrows the universe of managers from hundreds—and in some cases even thousands—to a manageable number for consideration. We use a set of relatively simple criteria that focus on cost, historical performance, and manager tenure. Shown below is a simple list of the steps in the screening process:

  • Source managers based on the style universe as defined by Morningstar and Zephyr 
  • Manager’s expense ratio must be less than the category average 
  • Manager must have at least three years’ experience managing the fund or a similar strategy 
  • Management must be consistent with stated objective of the fund (style and market segment) 
  • Review risk-adjusted returns outperforming benchmark over multiple rolling time frames 
  • Universe for consideration 

These are minimum criteria and our goal is to find the best manager/fund that we can at the lowest cost possible. For example, we don’t typically look for portfolio managers with just three years of experience but need to draw the line at a point that both narrows the universe and shows some track record in managing a pool of assets. I would also point out that we evaluate past performance solely as a means of gauging a manager’s track record for luck vs. skill. We look at performance over multiple rolling timeframes, which eliminates specific timeframe bias. Put more simply, a manager can have an exceptionally strong quarter that will filter through to three-, five- and 10-year performance numbers. That portfolio manager might have been very ordinary except for that one quarter. We view that as luck, not necessarily skill. When looking over multiple rolling time periods, it becomes easily discernible whether a manager has achieved a good number through one lucky period or consistent performance over a market cycle or cycles. 

Limiting cost is very important to us and is one of the primary screening criteria. Multiple studies have been conducted that show reducing investment expenses can provide a “head start” on returns. Put another way, none of us know what future market returns will be, but we do know what an investment manager charges, and we strive to reduce those expenses to the benefit of investors. It is, however, important to note the difference between expense and value. The more difficult or less efficient a market sector is, the more valuable portfolio and risk management are, which typically means a slightly higher expense ratio. For example, emerging-market equity managers tend to have higher expense ratios than domestic large-cap managers, and portfolios that use long and short positions for profit opportunities or as a means to hedge risk usually have higher expense ratios than more traditional “long only” managers.  

The end result of the quantitative screening process is a list of asset managers that potentially might merit further consideration. These lists are broken down by category (i.e., large-cap vs. small-cap vs. international) and then ranked based on additional criteria and with more detail. The end result is a list of potential candidates in any asset class that meet our minimum criteria for inclusion as a recommended fund. Think of the recommended list as the starting team and this list as the bench of a sports team.

Qualitative Review

The qualitative review of managers runs on two separate tracks. The first is meetings with managers over the normal course of business, either when they are on the road or when a member of the Moneta investment team is traveling. These meetings keep us generally apprised of things such as performance attribution, changes from an organizational structure, or changes to the investment team or process. 

The second track is formal due diligence when a need is identified to add or replace a fund. We select the top-rated funds from our previously described “bench” (typically three or four), and over a series of calls/meetings we learn more about their people and process. Typical topics include firm organization and structure, compensation practices, investment process, capacity for the strategy, concentration (by client or firm) of assets in the fund, as well as other topics. The goal isn’t necessarily to find the manager with the best recent performance (remember past performance is no guarantee of future results) but to identify portfolio teams conducting thorough analysis and using an explainable, repeatable process to build portfolios. 

This qualitative review is a learning opportunity and there are both evergreen core topics and questions that change little, as well as topics made timelier by recent developments. One example is spending more time in recent meetings on the topics of organizational structure and compensation. With the markets strong and business for asset managers generally good we have seen a higher degree of movement by portfolio managers (similar to free agency in sports). It is very disruptive as a fund investor to have the portfolio manager leave with his/her track record. This concern can be mitigated by ensuring a robust portfolio management team with a succession plan and also through key personnel having contracts with equity ownership attached to it. 

Ongoing Monitoring

Ongoing review is accomplished two ways: first, through the aforementioned meetings that happen through the normal course of business; and second, through periodic performance review. Knowing a manager’s philosophy and style is very important when reviewing performance. Within growth categories there are actually multiple styles, each with different performance patterns. Growth at a reasonable price (GARP) managers have some core or value characteristics to their process while another growth manager might focus only on earnings growth and another might look at market momentum as part of the process. Each style can (and usually does) perform differently at various points in the cycle despite all being considered “growth.” 

Other Considerations

In addition to the three steps mentioned above, there are other considerations when we are conducting due diligence. In no particular order, these include:

  • Philosophy relating to turnover and portfolio activity.  We generally prefer funds that have lower turnover. The potential benefits of this philosophy are lower internal costs related to trading and more tax efficiency.
  • Acknowledgement that all portfolio managers eventually experience a period of poor performance. This is true regardless of asset class or strategy. However, in our experience, good people coupled with a good process and patience results in good performance over the long term.
  • An emphasis on intermediate- to longer-term time frames. Most of our clients are building portfolios with long-term horizons. While no one likes to see a manager post a poor performance year, we must acknowledge that it happens. But instead of firing a manager for one poor period, we remain focused on the people and process and longer-term performance.
  • Dedication to style and process are important to risk management. When constructing a portfolio using multiple managers it is important that they adhere to their mandates so a portfolio doesn’t end up heavily weighted to one style or market sector. In the “Tech Wreck,” many value managers found “value” in tech stocks, which were also a favorite of growth managers. As a result, many portfolios ended up with a concentration in one sector and performance suffered.  
  • A desire to be “sticky” and relevant. If we identify good managers through the due-diligence process, we reduce the need to constantly hire and fire mangers. We also want to have enough assets with managers to have access when necessary. When adding a new fund, we are negotiating on behalf of all of Moneta’s clients. To put it in perspective, we provide guidance to potential new fund/manager relationships to expect approximately $50 million in the first 12 months of a new fund being added to the recommended list.
  • Remain agnostic to “star” ratings. Many of the services that rate mutual funds focus on recent performance, which we view as only one input. In our experience, many funds with poor to moderate ratings are benchmarked inappropriately. As an example, one major service benchmarks many hedged and asset allocation strategies to the S&P 500. In a year such as 2013, these funds are not going to keep pace with the 25%-plus returns of equities and will have poor ratings. These funds are not designed to keep pace with equities and have a different role in a portfolio.

Disclaimer: Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express of implied, is made regarding future performance. 

The information contained herein has been compiled from sources believed to be reliable however MGIA makes no representations and has not conducted independent research as to their accuracy or completeness. This report is provided to you for information purposes only and should not be considered as an offer or solicitation to buy, sell or subscribe to securities or other financial instruments. 

Alternative investments are often complex investments, often involving a high degree of risk and are intended for sophisticated investors capable of understanding and assuming the risks involved. The market value of any alternative investment may be affected by changes in economic, financial and political factors, time to maturity, market conditions and volatility, and credit quality of any issuer or reference issuer.  

The opinion expressed herein is that of MGIA and is subject to change without notice and should not be relied upon in substitution for the exercise of independent judgment.