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  • Nathan Greene CFP®

What Is Proper “Due Diligence” on a Portfolio Manager or Mutual Fund?

Investing today is complex. For all that has been done to make #Investing more accessible to the individual investor, what we’re left with is just a giant, complicated web of options, comprised of thousands of mutual funds and even more portfolio managers all claiming the same thing: that they’re better than the competition. So with all these different funds, managers, and strategies, how can one separate itself from the rest? In other words, how do you know which one is the right one for you?


We cannot find the answer without effective due diligence #Research. In a sense, we’ll never be able to predict beyond a shadow of a doubt when one fund/manager/strategy will outperform another over a given period of time (plus, looking at it through that lens what we call “Results Based Analysis,” and that isn’t a helpful way of analyzing investment decisions), but there are many factors that can contribute to a higher likelihood of success. Some of these factors are objective, IE there are good practices and bad practices, but others are much more subjective, meaning it’s not about “best practices” but instead about the right fit for your portfolio.


This post intends to share what Cairn Financial Group believes to be important factors in determining the appropriateness of one strategy, fund, or portfolio manager over another.


Before we get started, let it be stated that there is no uniform approach to due diligence research and this information should provide insight into what Cairn Financial Group prioritizes in its manager selections. Our hope is two-fold: (1) to empower you in your own decision making, particularly as it applies to managing investments like your #401k, and (2) to inspire faith and trust in our process, hopefully leading to more confidence in your relationship with us as your investment advisor.


Factors To Consider in Your #DueDiligence Research

Firm

Do you sufficiently know the firm that you’ll be entrusting to oversee your money? Behind these portfolios are always a group of people and/or a corporate team. Getting to know them is fundamental to trust their process. What you’re trying to identify is whether the firm actually values you as a client and whether you are a part of their long-term vision. This carries qualitative impact, of course, but it also has a quantitative impact in that different types of clients may affect trading operations, approach to risk, and much more.


You’re also looking for sponsorship in your strategies. Sponsorship identifies – either through direct ownership in the firm or indirect compensation tied to the strategy – whether key decision-makers and portfolio managers have a vested interest in the success of the strategy. In other words, are the appropriate decision-makers in the exact same boat as you? Or do they just come to work for a salary regardless of the success of the strategy?


When researching the firm behind a given strategy some key points to consider are:

  • History and progression – When (and why) did the firm start, and how has it evolved over time?

  • Current ownership – Who currently owns the firm, and importantly, what is the succession plan?

  • Mission – Understanding the firm’s purpose is a crucial step-1 analysis for knowing the firm.

The firm’s size is also an important factor as it applies to assets under management (“AUM”), clients, and support staff. While more may seem better at first glance, that’s not always the case. More AUM means the firm (and the fund) have to make larger trades in order to buy into or sell out of a security. And since the stock market is (oversimplified) just a giant auction, this may lead to the firm not receiving the best price for their trades. For example, let’s compare this to selling lawn mowers on eBay. If you have to sell 1,000,000 lawn mowers, you may not be able to get the top price for the whole batch, but if you only have to sell 1 lawn mower, it’s feasible that you can set a higher price! On the other hand, a smaller firm may not have the stability, capacity, and continuity of a larger one. Due diligence should effectively assess if AUM, clients, and support staff are balanced and at an appropriate size for what you desire.

Management Team

Due diligence research on a management team is similar to that of the firm itself, although it is more focused on those in charge of the specific strategy in question. Key aspects include the portfolio managers’ experience, designations, consistency, and sponsorship.

  • Experience – How long have they been doing what they do?

  • Designations – How many of them carry the CFA (Chartered Financial Analyst) designation (or other relevant certifications like Ph.D.)?

  • Consistency – How long has the team been with the strategy?

  • Sponsorship – Relative to their net worth, how much does the team have invested in the fund?

Also, assess the level of access to the management team and their communications. Will you be able to stay informed about the strategy as it develops? Better yet, when it underperforms, will you be able to look under the hood, so to speak, and understand the source of the performance issues?

Philosophy and Objective

As a Registered Investment Advisor, Cairn Financial Group has direct access to speak with management teams and firm owners as discussed in the previous few categories, but this may be difficult to replicate as an individual #Investor. Therefore, the next few categories may be more relevant for those looking to research on their own.


A strategy’s philosophy and objective are the “worldviews” that shape its decisions. In a sense, this may be the most important part of due diligence research on any strategy. However, it’s difficult to say that one philosophy is inherently better than another. Instead, we believe that a proper understanding of a strategy’s worldview helps us understand how to position and utilize that strategy in the overall portfolio.


Consider two separate large-cap domestic (U.S.-based) funds. One fund benchmarks itself to the Russell 1000 Growth index and limits itself exclusively to #Stocks represented on that index. The other fund limits itself to investing only in large-cap U.S. domiciled stocks (whether or not they exist in an index), and its objective is to outperform the S&P 500. As an investor, can you objectively say that one philosophy is better than another? Unless you have a crystal ball that predicts returns for these two indices over the next market cycle, probably not. The best you can do is identify which philosophy matches your market outlook and position appropriately.


Matching philosophies is important. Many investors prefer to have funds and strategies that stick to explicit and clearly-defined lanes so that they (the investors) can shift exposure to different economies and philosophies as they need. Other investors, however, prefer that their fund managers have the flexibility and autonomy to shift their holdings to the best opportunity with as little restriction as possible. Neither is inherently right, but one may align with your own portfolio-management preferences more than the other. Maybe a better way to position this concept is that misunderstanding the fund’s philosophy could lead to misuse (and therefore potential underperformance) of the fund itself.


In researching a fund’s philosophy and objective, pay attention to its:

  • Objectives: What is the goal of the fund, and how will it achieve that goal?

  • Adaptation vs. Conviction: Does the strategy reactively evolve in response to the market or proactively maneuver through the market with conviction?

  • Benchmark: To what index does the fund benchmark itself, and does the management team care about outperforming it?

  • Market Cycles: What market environments should lead to the fund outperforming its benchmark? What about underperforming?

  • Role: Does the fund operate best as a sleeve holding (a small segment of your overall portfolio) or as a complete portfolio?

Strategy Overview

Reviewing the ins-and-outs of a fund’s strategy is immensely nuanced and will be the subject of a future blog post by itself! The purpose of a #Strategy overview is to become familiar with the decision-making process of a fund. How would you categorize the management style? What does the life-cycle of a holding look like? In other words, how does a security move from an idea to a watch list? Then what triggers its purchase, rebalance, and eventual sell? In essence, you’re trying to identify what competitive advantage this fund has over its peers.


To avoid a boring level of detail (and keep material for a future post), we will limit our exploration of the Strategic Overview to focus only on the life-cycle of a holding:

  • Idea Generation: How are ideas sourced? What universe of securities does the fund pull from? Are ideas generated "top down” or “bottom up"? Are there any preliminary screens? What about that process is repeatable?

  • Watch List: How does an investment qualify to be an addition to the portfolio?

  • Sizing: How does the management team determine how much of a security to buy or sell?

  • Rebalancing: What causes the firm to shave down or add to a position?

  • Sell Discipline: When does the team fully liquidate a position?

Portfolio

#MutualFunds, in particular, offer limited transparency into their holdings within a fund at any given moment. The SEC requires mutual funds to provide a full report of their portfolio at least once/quarter, but that only acts as a snapshot. It’s difficult to know the details of a portfolio without more thorough research, and that’s what due diligence research ought to answer.


Research into a portfolio’s current composition begins with identifying all the current holdings in the fund. Of course, it doesn’t stop there... Effective due diligence should result in a clear understanding of the thesis behind each holding within a portfolio. In other words, you should know why a portfolio manager has decided to take the positions they have and what they believe is each position’s upside and downside.


Understanding the thesis for each holding in a concentrated portfolio may be a relatively easy process. However, for diversified portfolios, consider focusing on a limited – but fully representative – number of holdings. Including holdings in which the management team holds the highest conviction as well as those with the lowest conviction.


Understanding the target length of an investment, and turnover within the portfolio is also important, even if only for tax purposes. Finally, it’s worth knowing if there are any maximum or minimum rules applied to any sectors, credit ratings, geography, or position-weight. Much like the “philosophy and objective” discussion above, there is no one right answer to the questions of max/min limits, but this should reflect how you see the market.


Understanding the details of a #Portfolio means being able to answer questions such as:

  • Current Holdings: What securities does the fund currently own and why? What is the number of securities/diversification?

  • Investment Lifecycle: What is the target length of investment and turnover?

  • Alignment: Does the current portfolio match the stated philosophy?

  • Parameters: Are there sector/credit/geographical or position weight max/min limits?

Performance

For most people, performance is where due diligence begins and ends. Particularly given how information is presented on a 401(k) platform, it’s easy to look at historical performance data and construct a portfolio based on returns. However, when we at Cairn research the “performance” of a fund, objective returns are often not the primary decision factor. As mentioned earlier in the article, “Results-Based Analysis” is a dangerous way to assess decisions in the investment market. In other words, our primary goal isn’t to find “what worked” but instead “what will work.”


Of course, “objective returns” is the primary goal, so even though a fund’s past performance is not indicative of future returns, some underlying factor existed to generate those historical returns! We’re simply looking to see if that underlying factor is repeatable, or if it was just luck.


An important starting point is to understand how the fund managers measure #Success (and over what time frame). It may come as a surprise that not all managers have the same definition of success for their goals or returns. Based on their definition of success, assess how consistently they’ve been able to accomplish their goal. Also, try to understand the effect that different market cycles have had on its performance. Some active strategies are well-positioned for specific market cycles and poorly positioned for others. While other strategies may be designed to withstand the test of time.


Furthermore, there are a few active measures that can quantify a fund’s performance productively:

  • Alpha: When adjusted for risk, how much extra return was generated over the relevant benchmark? (This is widely regarded as the best measure of performance)

  • Active Share: How much of the portfolio overlaps with the relevant index?

  • Capture Ratios: How much of the relevant index’s upside does the strategy tend to capture? Similarly, how much of the index’s downside does the strategy tend to capture?

Lastly, don’t forget to assess the expense ratio of a fund. Yes, high fees take away from your return, but “low fees” are not always the sign of a good investment strategy. High net-return is what you’re after! Be cognizant of a strategy’s fee ratio and audit that fee to the point where you are confident that it will generate more net value than cheaper alternatives. If you are not confident that a higher fee strategy will produce a higher net-return, then default to a lower-fee option.

Risk Management

The final factor in a thorough due diligence process is to assess how a fund manages its risk. Each manager will have a different approach to managing risk, and there are even different ways to quantify it. The most common measure of risk is quantified as Volatility or Standard Deviation. #Volatility in and of itself may not be very relevant on paper if you have a long time frame to invest. However, volatility is important because of the emotional affect it has on you as an investor.


Along with volatility, other managers will simply measure the risk of “permanent loss of capital.” This risk can be addressed in one of two ways. First, by diversification, or attempting to minimize the effect of loss. For example, If I own 10 pencils, 23 pens, 13 sharpies, and 2 crayons but one pencil breaks, it’s safe to say I will still have the ability to write something down. Secondly, managers can address risk through conviction and absolute confidence in the business model of your investment. IE I only own 5 pencils, so I need to be VERY confident they won’t break.

Be sure to ask about position limits as well as market exposure. In other words, what is the long/short/net exposure limits within the portfolio? Is it possible for this fund to “short” a stock like GameStop? Or is the strategy “long-only”?


Pay careful attention to some of the following Risk Management questions:

  • Risk Philosophy: What is the firm's philosophy with respect to risk?

  • Risk Measurement: How does the firm measure risk?

  • Risk Management: How is risk managed - diversification? Tactical? Monitored?

  • Risk Parameters: Are there position limits?

  • Exposure: What is the gross exposure - long/short/net (think: Gamestop)? Does the strategy use leverage?

Conclusion

The process of thorough due diligence research on #PortfolioManager(s) and mutual funds might be incredibly in-depth, but it ought to leave you with the highest degree of confidence in the strategy serving you well into the future. If it doesn’t, that’s a good sign it’s not the right fund for you!


As a Registered Investment Advisor, Cairn Financial Group has direct access to fund managers so that we can spend immense time getting to know their personnel and strategies beyond what’s reported on paper. You may not have the ability to do the same, but we encourage you to gather as much information as possible in the process of making your decision(s). Start with the resources available to you through analysis groups like Morningstar.com, the fund’s website, and the like.


And of course, we hope this motivates you to reach out to us directly with your own questions – about the portfolios we already manage for you or even about those we don’t yet.


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