The Process of Judging an Investment Process

A couple weeks ago I looked some of the reasons behind the fact that smart money tends to chase past performance. I received a couple of good follow-up questions from people in the industry who were curious about my thoughts on how to judge a portfolio manager or investment process.

Putting together a portfolio using a manager-of-managers approach is extremely difficult. Not only is it tough to beat the market, but it’s also very hard to put together the right type of organization and team in place that can successfully perform the due diligence and monitoring required to judge a group of money managers.

I find it’s much easier to figure out the mistakes investors make and try to avoid those, but at a certain point you actually have to have a process for selecting and judging investment opportunities. Here are some thoughts beyond the typical due diligence routines that most firms discuss.

The ability to say no over and over again. The previous non-profit investment office I worked for had a fairly large endowment, but in the institutional space we were still considered something of a mid-sized fund in comparison to the much larger pension plans, Ivy League endowments and sovereign wealth funds out there. Even as a relatively small player we would still receive something on the order of 10-12 cold calls or emails a week from funds looking to pitch us. The number of available investment options seems almost unlimited when you include things like private equity, hedge funds, real estate and venture capital on top of the standard stock and bond fund managers.

You have to have very strict investment criteria because there will always be the temptation to make changes by adding new funds to the mix. Many of these funds have some of the best sales and marketing teams in the finance industry so they all sound like amazing opportunities. The trick is having the ability to say no to good or even great investments when they aren’t in your wheelhouse or when they aren’t a great fit within your portfolio or risk profile. A good set of guidelines about what it is you won’t invest in is just as important as outlining those characteristics that you will invest in.

The ability to judge the character of a portfolio manager and an organization’s culture. In some ways you almost have to be better at judging people than judging investments to succeed in this endeavor. Because you’re dealing with such intelligent people on the investment side and such skilled salespeople on the marketing side, you have to have a really good BS detector to see through the sales pitch.

Everyone will talk about what differentiates their firm or process from the market and their competition. Everyone has a great pitch book of marketing materials and a highly educated staff. You can’t get caught up in the narrative or become blinded by the brilliance of a slick portfolio manager.

The CIO of a large college endowment once told me that they hired private investigators to run thorough background checks on every single portfolio manager and team they hired. While this may seem like the prudent thing to do, shouldn’t it be a red flag if you don’t trust someone enough that you have to bring in Magnum P.I. to sort through their life? And don’t you think these people are already pretty good at hiding the skeletons in their closet if the have built a successful investment firm?

If you’re not able to judge the people behind the investment process to know that you’re working with an honest, trustworthy firm, it probably won’t matter how the investments perform. You have to be able to develop long-term working relationships with people of high character. This extends beyond treating their clients with respect. They have to also be good to their employees. The arrogant, self-absorbed portfolio manager might be a great investor, but odds are eventually they’ll come back to haunt you at some point. And if a fund manager makes it sound like they’re doing you a favor by letting you invest in their fund, it’s probably best to sit that one out.

The ability to know when a process is done working and when it’s just out of style. One of the hardest decisions to make in the investment world is distinguishing between an investment process that’s out of favor and one that doesn’t really work anymore. Regardless of how confident someone may seem, there’s always going to be doubt that creeps in when underperformance occurs. In this business you really have to own your decisions. You have to be able to understand why something works over the long-term, but not right now and also why it should continue to work in the future. And you can never become married to an investment or manager when it’s not working anymore. Having the ability to admit when you made a mistake is huge, but something highly intelligent people have a hard time accepting.

To state the obvious, none of these intangibles in the due diligence process are easy. Very few organizations have the resources, expertise or experience necessary to pull it off successfully over the long-term. But no one ever said successful investing was easy.

Further Reading:
Organizational Alpha


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Discussions found on the web
  1. edinvestor1 commented on Jan 25

    Two things:
    1. We have met the enemy and he is us.
    2. My lawyer told me decades ago: “No matter how good and thorough the contract is, if you deal with a crook, you are going to get screwed.”

    • Ben commented on Jan 25

      Well said and I agree. Most of the problems are self-inflicted. My take has always been that career risk is the biggest issue for these funds to deal with.

  2. MG commented on Jan 25

    I steer investors to an easy way to avoid having to judge the intangibles in the due diligence process; I tell them to buy a low cost standard ETF from Vanguard, or like the Fidelity Spartan brand, such as a Total Market Fund. These almost always beat the money managers over the long term, don’t require one to judge the people behind the investment process, and over the long term never stop working!

    • Ben commented on Jan 25

      Yeah that was actually the first thought that popped into my mind when I heard about that — no need to worry about a background check on an index fund or etf.

  3. Chris_Wo commented on Jan 25

    Why wouldn’t you do your own background check on every portfolio manager being considered? You’re going to turn over millions of dollars to them.

    Individual investors can’t even rely on sites like BrokerCheck. This article mentions how often an adviser’s disciplinary records are expunged. “Deleted: FINRA Erases Many Broker Disciplinary Records”

    • Ben commented on Jan 25

      True, but the counterpoint to this is how much due diligence was being done on Bernie Madoff but he was still able to get away with his Ponzi Scheme? My point is that even a background check doesn’t mean you’re going to find every fraud.

      • Chris_Wo commented on Jan 25

        No you’re not going to find every fraud, but you can find behavior that might lead to it.

        Money managers like to keep up appearances, and that alone can keep clients satisfied that things are going okay. But a good background check can uncover problems below the surface—a personal bankruptcy, multiple DUIs, lawsuits by creditors, a nasty divorce. All things that can cloud one’s judgement and lead to poor decision making or financial slight of hand.

        If you’re entrusted to find managers for other people’s money, you should make the effort to find out everything about the money managers you hire.

        • Ben commented on Jan 25

          Definitely. I just think that some people can be too trusting of a background report. One of many arrows in a quiver is all I’m saying…

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