Early on in my career a portfolio manager told me a little secret about the money management business. He said, “Every professional asset allocator we talk to says they’re looking to evaluate our shop based on the four Ps — people, process, philosophy and performance. The four Ps are actually performance, performance, performance and performance.”
Everyone uses the disclaimer that past performance is no guarantee of future results, but it’s definitely the standard that everyone uses to make their future allocation decisions. Tom Brakke recently shared a great post on this subject that really hits the nail on the head here:
If you ask those involved in manager selection how much performance counts in their decision making, you tend to get an answer like “around twenty or thirty percent,” and sometimes even less. However, if the very first step in the evaluation process is a performance hurdle, in actuality performance becomes the primary governor on the entire effort and is therefore the dominant factor. Without past performance, you don’t get into the ring.
It’s no wonder why allocators start there. Nothing compares with the ease of a performance screen to cut the universe of possibilities down to size. (In fact, many screens include a myriad of performance metrics that make the constraints very tight, as if being more precise in filtering redeems the flawed premise of the exercise.) Faced with a large number of potential managers, nothing culls the herd quite so quickly as screening, even though that means that many prized bulls of the future are left out and a lot of bum steers who were lucky in the past are kept in.
I’ve spent a good chunk of my career evaluating and selecting outside money managers and funds, first as an investment consultant and then on the staff of an endowment fund. I can verify that Tom is correct based on my experience working with and getting to know many different institutional funds and consultants. Everyone talks about process but looks at performance.
I’ve covered the performance chase by the smart money in the past, but here are a few other thoughts on why money manager due diligence can be so challenging based on my experience with this process:
There are so many funds out there to choose from. In my previous role I probably received a minimum of ten cold calls or email fund pitches a week from prospective managers. And this goes beyond the thousands of mutual funds and ETFs out there. There’s a large number of managers who strictly target institutional clients with separately managed accounts with huge minimums. Then you have ten thousand hedge funds along with private equity funds, venture capital, real estate, infrastructure and the list could go on. I was always surprised by the number of firms who were managing many billions of dollars that I had never even heard of before. The choices are never ending, so the temptation to make portfolio changes will always be there.
When everyone is differentiated, no one is. These managers all have a great story to tell about their edge, what differentiates them or why they have a leg up on the competition. Very few potential investors spend the time figuring out how realistic these claims really are because there’s no way that all these funds have an “edge.” These claims are rarely backed up with hard evidence.
Peer recommendations. When going outside of the standard performance screen in a manager database, most institutional funds will first go to their peers in the industry. When they need a new manager the easiest way to get ideas is to talk to their fellow allocators at various endowments, foundations or pension plans. And when asked, no one in their right mind is going to recommend a poorly performing fund or manager. They only tell others about the best performers of the group and that’s who these other funds usually go with. This is how the herd mentality begins.
Now here are some of the most common mistakes I’ve witnessed from allocators performing manager due diligence:
Confusing investment opportunities for an investment process. Certain styles of investing or managers are better suited for certain market situations. Needless to say, it’s not easy to pick and choose these opportunities ahead of time. Not only is this much more difficult to pull off, but most institutional investors don’t have the governance or system in place to even pursue an opportunistic framework. Yet they try anyways and usually end up fighting the last war. A process is not a list of current investment opportunities; it’s a framework that guides your actions.
Not understanding their own portfolio or philosophy. With a near-unlimited supply of new managers and investment ideas it becomes a challenge to sit still and do nothing. Those funds who don’t have a well-established and documented philosophy are the ones who are constantly making unnecessary and costly portfolio changes. A portfolio is a sum of the parts, not just the individual funds or investments. Knowing what you will and, more importantly, won’t invest in is half the battle. You have to know when to say no.
Not asking the right questions. Experienced money managers know the questions you’re going to ask them and they have a finely crafted answer for every single one of them. This is mostly because the due diligence process has been turned into a checklist with mainly legal and quantitative questions. These checklists can help, but they’re just the first step. Many ignore the more important, yet harder to pin down qualitative questions:
What if you’re wrong? How will you know?
How do you treat your employees?
How do you treat your investors?
How do you decide on your risk and return targets?
What happens if and when your process stops working for some time?
What are we missing that’s not in the pitch book or DDQ?
What is the real differentiation of this strategy?
Are these good people you would be willing to partner with for a number of years?
If I had to choose just one of the four Ps I would always go with people. I would rather invest with someone who is forthcoming with their communications, admits their mistakes and looks at investors as long-term partners over someone who’s a brilliant, arrogant jerk with a great track record (these people usually run into trouble eventually). It pays to work with good people.
Judging someone’s character may be one of the most important aspects of the due diligence process. It’s also one of the hardest.
Starting Somewhere (Research Puzzle)
Three Characteristics of a Successful Investment Firm
I bet it would be short-term painful but long-term profitable to find the smartest guys with the best process in the most hated, bombed-out sectors/geographies, since that would be the only time they would have trouble raising funds.
E.g., rolling out of apartments, hotels and senior housing and into energy and southern Europe. Easier said than done, though.
Yes, value investing as they say is simple but not easy.
“…most institutional investors don’t have the governance or system in place to even pursue an opportunistic framework.”
I’m curious, do you have a view on what governance and systems could allow an opportunistic framework in a reasonably large institution? Have you seen anyone do this well?
Yale and David Swensen in many respects. It’s not necessarily being tactical, but in having the trust in the people you pick to manage the portfolio and not micro-managing them. The way I look at it there are two types of fiduciaries in the inst’l world:
1. Governing (committee/board)
2. Managing (PMs/CIOs)
Both play a role but often times the governing body tries to be a managing body and that’s never gonna work.
“With a near-unlimited supply of new managers and investment ideas it becomes a challenge to sit still and do nothing.
In order to meet the expectations of clients and, of course, acquire new clients, managers must always appear to be “doing something.” The problem is that any real market advantage tends to quickly diminish in value as the latest/greatest idea is copied throughout the investment industry.
After a career spent pursuing the latest investment ideas, it strikes me that the greatest value a manager can provide is the discipline that will prevent their clients from making the sorts of bad decisions that undermine long term investment goals. Unfortunately, this can involve a lot of doing nothing, which can be a difficult sell to many clients.
Yes, doing nothing doesn’t come across as working hard to an investment committee even when 99% of the time it’s the right thing to do. A lot of unnecessary fees and risk happen because people want to look busy
If you were a start up investment manager today, how would you go about it then?
for instance I’ve a solid track record coming up to 3 years now managing my own capital (25%+ cagr). And I’m thinking of going down the route of managing OPM…but I have reluctance:
a) It’s boring to be like all the other funds
b) I don’t know if I’m skilful or lucky (probably both)
c) I don’t have financial services background (I have a business consulting one) so no connections
d) I’d have to spend time away from investing and more time in “marketing”, this is inevitably bad for performance and
e) I don’t know if I would have the patience with investors calling me up daily/weekly in volatile times fretting (I prefer the Buffett way of permanent capital) when I’m a long-term value guy.
Any advice for a newbie?
Shoot me an email and I’ll give you some thoughts on this