Back to Portfolio for the Future™

The Often-Forgotten Art and Science of Manager Due Diligence

By Shana Sissel, CAIA - Chief Investment Officer of Spotlight Asset Group For almost two decades I have worked in roles that were heavily focused on investment manager due diligence across asset classes and legal structures. I began my career in due diligence-focused on the world of hedge funds. Hedge funds, in particular, are often viewed with a more critical eye than their more regulated counterparts. It’s often taken for granted that if a structure is more highly regulated than it must have lower risk. That couldn’t be further from the truth. In my opinion, having a clear set of guidelines for due diligence is a critical part of being a good fiduciary. It reminds us not to be too distracted by slick materials, stellar performance, and portfolio managers with impressive resumes. A few months ago, a conversation with a peer about manager due diligence delved into how, often, many investment professionals in the industry miss the basic red flags in the beginning of reviews that could save a lot of time and protect professional credibility. It led me to put together a list of what I believe to be the most commonly missed, but crucial, steps in manager due diligence. The steps that help you weed out problems before spending too much additional time analyzing a strategy or firm. In my opinion these 10 tips will help you avoid a lot of hassle and headaches, make the time you spend on manager due diligence more effective and reduce the probability of having a major public relations nightmare in the future. Always review the disclosure language in the documents they provide. Disclosure language is such a critical part of due diligence reviews. Often all the red flags and caveats are hidden here. We all know no one likes reading the fine print, but when it comes to due diligence, the fine print is where the red flags usually lie. Common items that are hidden in the disclosure language include:

  • Back-tested performance details,
  • Composite hedging language,
  • Performance caveats, and
  • Unusual fee disclosures.

Use common sense when reviewing return-based metrics. If certain periods standout as unusually good or bad, ask for insight/information as to how/why they performed the way they did in that environment. It is human nature to look at really good or really bad performance with an emotional tilt. I believe we should always try to look at returns with a skeptical eye. Understand basic operational & compliance structure. Almost any basic due diligence questionnaire includes sections of compliance and operational procedures, but oftentimes the investment due diligence team overlooks these areas. Good operational procedures and compliance policies can save you from a lot of headaches on the investment side. Some key areas I like to focus on:

  • Trading procedures including best execution, dealing with illiquid securities and trade errors;
  • Composite calculation methodology, GIPS Compliance (if applicable);
  • Currency exchange procedures (especially important with sub-advisors who may use a different service provider for currency exchange/hedging);
  • Prime broker information;
  • Pricing methodology. For 40 Act-compliant international funds; fair value methodology. Fair value calculations are not standardized across the industry. Everyone has different rules;
  • Regulatory filings and issues;
  • Fund accounting; and
  • Client reporting procedures.

If a firm uses shorting or leverage in their strategy make sure you understand how this is executed. It surprises me how often derivatives are used for execution, but no one realizes it and/or understands the implications of that. Review the portfolio holdings. Even if they give you stale holdings the portfolio construction and underlying positions should make sense with the strategy. Look for positions that don’t seem to align with the discipline and ask about them. Always be slightly suspicious of strategies whose performance vs. benchmark is “too consistent.” No one bats 1.000, even the best investors in history have gotten it wrong once or twice. Almost every major fraud by an asset manager involved a suspicious return pattern. Beware of hidden costs, fees are not the only cost. Understanding what the real cost to execute the strategy is as important as performance. Trading costs, margin costs, currency exchange are all real yet often not explicit costs that are obvious in fee schedules, they do chip away at returns and can harm clients in other ways. Risk management is more than a stress test or a Barra[i] Risk management can include limitations and procedures to deal with errors of any kind. Knowing your market risk exposures is one thing, but there are other risks that should not be overlooked. Make sure you understand how they define buzz words. Leverage can mean debt/equity or debt/capital, but it can also be cash flow-related. Quality can mean many different things. Strong management, intrinsic value, etc., all mean different things to different people. There are no hard and fast rules. Some PMs really can manage huge asset bases (not many), capacity constraints can be flexible depending on resources, large/small AUM isn’t always indicative of skill or professionalism. BONUS: Quants should be able to articulate their process to you in some depth. Any quant that just gives a vague process description while claiming “proprietary” is problematic. I don’t need the secret sauce but claiming proprietary is like pleading the Fifth to me. A portfolio manager should be able to talk about their strategy and provide insight to help establish performance expectations. If they seem to use “it’s proprietary” and an NDA isn’t an option, I consider that in itself a red flag and move on. There you have it, my list of often overlooked areas in the due diligence process. These aren’t the only things to focus on, but they are the key areas that can save you a lot of time and stress in the decision-making process. [i] BarraOne is a research-driven platform that helps asset managers identify and manage risk exposures to make more informed investment decisions. It is a commonly used risk-management tool owned by MSCI, Inc. Shana Sissel, CAIA is Chief Investment Officer of Spotlight Asset Group.

Interested in contributing to Portfolio for the Future? Drop us a line at