April 13, 2011

Is Due Diligence Keeping You Awake at Night?

Prima Capital’s Gib Watson speaks about when it makes sense to outsource CIO responsibility

If recent headlines in which some large broker-dealers are paying out millions or even hundreds of millions of dollars in regulatory fines, restitution or awards to investors aren’t enough to keep firms, reps and advisors awake at night, the impending effects of new regulation just may be.

Firms will need to be able to point to their due diligence process and show that it is robust. This underscores the urgent need for deep due diligence. Is an in-house chief investment officer the answer? Or is it better to outsource this critical function? 

Some would argue that the financial crisis alone was enough for many wealth management firms to feel the need for increased due diligence. And the best of firms are re-thinking their due diligence process, not simply on the securities level, but “strategically,” according to  J. Gibson Watson III (left), president and CEO of Denver-based Prima Capital, a firm known for its deep research bench and due diligence on SMAs, mutual funds, ETFs and alternatives.

We have seen firms of all shapes and sizes questioning their best practices—how they render advice to clients. They are questioning the construction of their wealth management platform,” Watson said. Some of the questions they are asking now, Watson says, include these:

  • “Do we have too many managers? Too few?"
  • “Do we have investment quality?”
  • “What about alternatives? Should we be including alternatives on our platform and, if so, what type?”
  • “What about asset allocations—are our clients’ portfolios adequately diversified?”
  • “Do we need to introduce additional asset classes, and if so, which ones, and how do we do it?” 

“Given the compression we saw in asset values coming the through the credit crisis, and the focus on not only top-line revenue growth but bottom line margins, the argument for outsourcing that chief investment officer (CIO) function is better than ever.” It is, Watson argues, a “sound strategic decision to outsource that responsibility to experts in the field.”

Being the “outsourced CIO for big banks and broker-dealers” is a  “core part of business” for Prima Capital, says Watson. But his firm has recently added a group of modular offerings for smaller firms, including the one or two-person RIA.

Prima Capital is helping client firms to put in place “best practices for due diligence.” Watson says one of the main areas where due diligence is headed is a focus  on the “qualitative” aspects of due diligence rather than the “quantitative.”

How Is This Research Different?

Before the crisis, Watson explains, wealth managers “relied on Morningstar’s star ratings and historical returns to select managed investment products to recommend, but now, advisors, brokers and individual investors alike appreciate the value of the qualitative due diligence.” It’s not just the returns over time, that are important, he says, but

the culture and “qualitative aspects of the asset management firm to manage that portfolio; the quality, the sustainability and the repeatability of that investment management process; the quality and the credentials of the people that are actually managing those portfolios; and the stay-in-place factors that are really behind those people.” 

These “stay-in-place factors,” Watson explains, include people managing the assets and the asset management firms include their “equity ownership, their compensation plans their satisfaction with where they work and how they work. So it’s that deep dive on a management consulting level into that firm to really get at a lot of these qualitative issues.”

What Makes Asset Managers Stand Out?

Watson looks for “active asset managers, whether for a separately-managed account (SMA) mutual find or ETF. I believe market inefficiencies do exist.” It’s these market inefficiencies that can help managers find alpha—but this must be combined with a process at the firms that they can articulate and recreate, that is essential, according to Watson.

His team looks for “those managers with clarity in their alpha thesis, who can identify and capture those market inefficiencies.” Once the investments are “in the portfolio,” Watson wants to know what the manager is thinking about “how long to hold and what are the triggers for harvesting alpha?”  

Prima Capital’s analysts look at “returns-based analytics, and holdings-based analytics to help us better understand what that manager is doing,” Watson explains. They look at “rolling analytics” rather than “point-in-time” returns, studying the “manager’s absolute return, relative return, and relative, risk-adjusted return—versus the appropriate benchmark.”

Watson wants to make sure wealth managers aren’t just making asset allocation, sector, style or security decisions in a “vacuum.” In Watson’s view, what Prima’s deep bench enables wealth managers to do is tackle the problem of “sorting through the clutter.” He notes that there is a “super-saturation of products, between mutual funds, SMAs, ETFs, hedge funds and funds of hedge funds—some 60,000 products.”

As one example, Watson cites the “216 open-end mutual funds of hedge-fund strategies,” that exist now. Many of these are managed by talented people, but for the mutual funds there isn’t a long track record. For firms that want to use the mutual fund vehicles that are managed with hedge fund strategies, historical returns won’t tell the story. But when Prima Capital’s analysts talk to the managers, visit the firms, and evaluate them on a qualitative basis, there’s much more to report than returns. That helps “separate the cream from the crud, ” Watson notes.

Part 2 Tomorrow: How Can Due Diligence Give Advisors Confidence? 

See thecomplete calendar of our SMA Special Reportfor past and upcoming coverage.

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