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Portfolio > Asset Managers

How Due Diligence Can Give Advisors Confidence

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As more and more wealth managers turn to independence to run practices in ways they believe are better for their clients and themselves, some, used to the infrastructure of large firms, become overwhelmed at the thought of performing the research and due diligence tasks that clients—and regulators—demand. But firms that serve these wealth managers are wise to this, and are offering ways to outsource important functions—such as the chief investment officer.

Not only are smaller registered investment advisors (RIAs) looking to outsource these functions; it’s also a trend in single- and multi-family offices and larger brokerage firms and banks.

Prima Capital serves as the outsourced chief investment officer to a number of big banks and brokers, 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.

At a time when Watson says firms are re-examining their best practices when it comes to  research and due diligence, his firm’s deep bench of analysts provide independent research, due diligence, allocation models, recommendations and manager monitoring on a subscription basis.

The Research Process

Prima Capital’s team collects” individual securities holdings for the portfolio,” to look at “returns-based analytics” and “conduct extensive holdings-based analytics on that particular manager,” says Watson.

Prima Capital looks at four “style sub-factors” when evaluating a manager’s style:

  1. A single-factor regression analysis
  2. A multi-factor regression analysis—returns based
  3. A holdings-based style analysis
  4. Manager’s discipline

The firm uses the individual securities holdings data it captures for holdings-based style analysis, displaying “each individual security in the portfolio on a bi-metric grid, plotting market capitalization on the vertical axis, and security characteristics on the horizontal axis, and you’ll see this scatter gram so that you can get a sense, at a point in time: How are the individual securities in the portfolio aligned, market cap versus security characteristics. So you can see what’s going in at the portfolio level.” This “x-ray into the portfolio,” notes Watson, provides a  “much better sense of the actual risk that’s going on at the portfolio level, for that particular manager.”

The Qualitative Deep Dive

Then, they look at the manager’s discipline and whether that “makes sense in terms of how they’re buying stocks—and is that presented in the holdings in the portfolio and further supported by the single-factor and multi-factor regression analyses that we’ve looked at over time.”

Each quarter, Prima analysts take month-end data and conduct a “holdings-based performance attribution analysis on the manager, and there we decompose the attributes of performance to tell us how much of the manager’s return that quarter was generated by the asset allocation, sector selection, security selection, or by the market timing and trading components.”

For example, for a “U.S-based large-cap, bottom up fundamental” manager, they would “expect to see the bulk of that manger’s alpha being generated  from their stock-selection capability, and secondly from their trading expertise,” Watson asserts. “In small-cap managers, where the markets are more inefficient than in large caps, we tend to see managers who add more value from market timing and trading expertise.” The analysts look to see if what they expect is what the holdings-based analysis shows.

“It tends to raise some red flags here at Prima if we don’t have some consistency and uniformity in terms of the manager’s investment process, and their philosophy—the whole discipline with which they’re managing the portfolio—with what we see in the quantitative data, particularly in the holdings-based performance attribution side of things,” Watson argues.

Looking at the Big Picture

A lot of advice is “not necessarily recommending a mutual find or a separate manager in a vacuum, but [advisors] positioning their value add as starting with asset allocation that is appropriate, and in the best interest of the investor. After you get that asset allocation established—then the job is selecting the appropriate asset managers to implement each sleeve of the portfolio.” But, Watson notes, “If you just look at returns coming from the manager, you’re going to miss the big picture.”

These advisors, who work with clients on a “holistic basis,” want to see how the managers “play together at the security level: Do I have evidence of a vacancy in my portfolio design [or] redundancy and overlap in other areas—and what does this do to the risk parameters around the portfolio that I’m constructing for my client?”

They can do a much better job as that holistic advisor if they conduct the right level of due diligence at the manager level as well,” in Watson’s view. “The trend has placed a greater emphasis on two benefits that due diligence consultants have always brought to the table: helping make the appropriate match—selecting the appropriate managers—and helping make better-informed decisions.”

‘Strategic’ Versus ‘Tactical’ Allocation

What about the question of “strategic” versus “tactical” asset allocation?

Rather than the “purely strategic” or the “purely tactical poles” of asset allocation, “We’ve favoring these days a more dynamic asset allocation—it’s more strategic. Based upon relative valuations of asset classes, you

can tactically overweight a portfolio to favor some of those undervalued asset classes. But it takes a systematic, disciplined process to have the proper set of global capital market assumptions to your return expectations and the ability to measure each of those asset classes on a quarter-to-quarter basis to see what’s working-not working, overvalued-undervalued. Some of the more dynamic shifts in the portfolio to take advantage of these undervalued opportunities.”

Not only is a thorough due diligence process required for advisors who are fiduciaries, but it would seem that this process could be an important differentiator, especially for smaller firms. If smaller firms could take on and use the institutional expertise of a deep bench of research analysts without all of the overhead, it would seem to be a win for advisors as well as clients. Wins for clients tend to bring more clients.

To that end, Prima Capital has developed a “modular, subscription-based research, due diligence and proposal generation” service, PrimaGuide Plus, that advisory firms can mix or match as needed. “It probably makes sense for an RIA [starting] at about $100 million in assets under management,” according to Watson.

Module one, says Watson, includes “research, due diligence, and advice on for SMAs, mutual funds and ETFs.” Module two, provides access to our front-end proposal generation system which includes a pretty detailed risk-tolerance questionnaire. There’s a scoring mechanism that plugs the results of that questionnaire into a library of efficient allocation strategies. This is a series of five risk-based portfolios ranging from a conservative, income-oriented portfolio to an aggressive, more capital appreciation, more equity oriented portfolio.”

“There’s one series of models with alternatives and one without alternatives because there are some advisors that are just uncomfortable using alternatives,” Watson notes. There is also a “current mix analyzer,” so an advisor can upload a potential client’s “current portfolio and compare it with a proposed portfolio. And it can generate an investment policy statement (IPS) in the system.”

The third module provides access to research on “non-traditional investments,” says Watson.

The second module “sits on top of the first module so” advisors can access the research on all of the products” that are in the application to “implement portfolios.” Watson says that different levels of research available range from a light level of research up through a qualitative assessment, to the actual  “managers we have recommended to [client] companies—so there’s an actual analyst opinion” from Prima’s analysts. The top of the pyramid is the “Prima Select list,” that,  Watson notes, is the result of a challenge to the firm’s analysts to “pick the best managers in your area of coverage and tell us who the top managers are, who you really like so that if you were investing your mother’s portfolio, who would you put your mother’s assets in? There are about 70 managers on that list.”

For a breakaway team that goes independent as an RIA, this could be a boon. The cost varies according to the number of advisors using the service, but for a small shop of two advisors, module one is $30,000; module two is $10,000 and module three, $25,000. While that’s not cheap, Watson points out that it is nowhere near the cost of “one analyst” and the advisors get access to the institutional quality research Prima’s deep bench provides. Prima Capital is offering a free trial of PrimaGuide Plus (as of this writing) on their web site.

See on due diligence in Is Due Diligence Keeping You Awake at Night?

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


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