June 5, 2012

The Most Important Question to Ask Money Managers

We’re aware that when some financial advisors hear the term “manager due diligence,” a nice tidy checklist comes to mind. We’re aware—and we understand—but it’s hard not to be a little disappointed. The thought that such a robust process—the classic combination of art and science—is ever reduced to something on the order of an eHow query always gives us pause. We’re pretty sure that selecting serious money managers for serious assets goes way beyond filling in a few blanks and checking off a few boxes. 

Let’s face it…it’s not that hard to quantify a few ‘Hows’ and ‘Whats.’ The real trick comes in qualifying the ‘Whys.’

Looking Behind the Decisions

Without question, inquiries that get to what a manager does and how he or she does it are an essential element of the evaluation process. An investment manager’s responses to these factual questions provide plenty of background. 

But the more revealing and meaningful insight is likely to be found in answers to the ‘Why?’ questions. Why has a manager chosen to do things in a particular way? Why does the manager think he has an unassailable alpha thesis? Why does he think he has an edge in exploiting inefficiencies? There are more and less effective ways to do things in the investment industry, of course, but there’s not likely to be one ‘right’ way. That is why assessing the quality of the thinking behind a decision is often more important than the decision itself.   

That can be said of business decisions that affect the investment process as well as the investment decisions themselves. Take an investment firm’s compensation plan. There are myriad ways to construct compensation plans for investment professionals so we’d be interested in looking past the factual elements of a plan to the logic behind it. What was the thinking that went into constructing a particular compensation plan and why was it executed? Which behaviors were being elicited and why are they considered important? Who is responsible for determining if the plan is achieving its intended effect and why does that matter to the investment process? 

Imagine the insight you would gain if you discovered decisions were being made with no evaluation of the results. You’d surely be inclined to question the rigor with which that manager approached the entire business.   

Moving the Conversation Forward

Applying the same concept to investment decisions, the answers to ‘Why?’ questions around a manager’s investment philosophy should be particularly enlightening. For instance, if a manager focuses on earnings revisions, we would want to understand why the manager believes there is a payoff to doing so. What is the specific inefficiency that the manager is trying to exploit? Why does it exist and why should it reasonably persist? Has the manager done the research to understand when his thesis works best, or, just as important, when it fails to generate strong performance?   

Each investment firm has distinguishing traits attached to aspects of its philosophy and process that set it apart. Understanding those differentiating aspects are what move the due diligence conversation past the quantifiable data. 

Here’s a simple exercise to practice the pursuit of why: Ask the manager to relate current holdings to the investment philosophy and process by following a holding from the inception of the idea through to its eventual sale. Ask ‘Why?’ throughout this discussion in order to gain insight into the degree of detail and intellectual honesty with which the process is employed.   

In an industry where there are few black-and-white issues, it’s hard to argue the importance of understanding the thinking that goes on behind business and investment decisions. That’s why we suggest honing in on why managers do what they do rather than just settling for what they do and how they do it. For our part as due diligence experts, we’re always looking for that select group of managers that can clearly articulate their thinking and stand ready to back up their claims with robust research.  And that takes a lot more than a checklist. 

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Author’s disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.

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