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  • 1. February 11, 2011 Webinar The History Of Manager Due Diligence And Where We Went Wrong Not Much Has Changed, But it Should Ron Surz, CIMA, MS, MBA President, PPCA Inc President, Target Date Solutions (949)488-8339 Ron@PPCA-Inc.com The Dark Ages 1
  • 2. The craft of delivering solutions 60s 70s 80s 90s 2000s Schlepper/ Performance Reports Manager Selection and Due Diligence Asset Allocation Trusted Advisor The craft of manager due diligence 60s 70s Indexes Peer Groups 80s 90s 2000s Blended Indexes & Custom Peer Groups
  • 3. It’s a Bad Joke …each money manager has ready stories about other money managers with low alphas who snatched clients through clever marketing. Professor Meir Statman I have never met a money manager who has performed below median. Every manager wins against the right benchmark. We cannot change what we tolerate. The Madoff mess was enabled by lax due diligence. 3
  • 4. Agenda  The Issues: Schools of Thought  Performance Evaluation: Benchmarking and Significance Testing  Attribution: Getting Whys  Proof of Better Living Through Science  Using What We’ve Learned: Recognizing Skill, & Portfolio Construction 4
  • 5. Schools of Thought Dave Loeper, President and CEO of Finance Ware Insufficient value added given the time, energy and money to do manager due diligence right. The potential benefits of manager due diligence are outweighed by the costs. Behavioral Finance Professor Meir Statman, What investors Want Investors demand active managers because they want to have fun, and they’ll pay extra for it. It’s similar to diners choosing fancy expensive restaurants. Dr. Frank Sortino, The Sortino Framework for Constructing Portfolios Optimize around talent by integrating active with passive. Use active where you find skill, and passive where you don’t. 5
  • 6. Winners and Losers: Use the right tools to address the 2 central due diligence questions: What does this manager do? Indexes Does he/she do it well? Peer Groups 6
  • 7. Truths 1. An index is NOT a benchmark, except for index huggers and indexers. Tracking error is neither risk nor value added. 2. Custom benchmarks best define what a manager does. The intent is to capture the People, Process & Philosophy. Building blocks (indexes) matter a lot. 7
  • 8. Dr. William F. Sharpe “It is desirable that the selected asset classes be: Mutually Exclusive (no class should overlap with another) Exhaustive (all securities should fit in the set of asset classes) Neither S&P nor Russell indexes Meet These Criteria “Determining a Fund’s Effective Asset Mix”, Investment Management Review, December, 1988, pages 59-69. 8
  • 9. Creating Mutual Exclusivity “Refining Core-Satellite Investing”, Journal of Performance Measurement, Fall 2010 9
  • 10. Surz Style Pure® Indexes Core behaves differently than value and growth Large Middle Small Value Core Growth Surz 1986 Morningstar 1997 2010 10
  • 11. Value-Growth Classification Price/Earnings  Book Value is a Stock Variable (Historical Accounting)   Earnings are a Flow Variable (Current) Price/Book Book values of some large banks are grossly overstated in this financial crisis “Becoming Style Conscious”, Journal of Investing, Fall 2010 11
  • 12. Whose Style is it Anyway? Classifying Financials in Q2, 2010 Surz Style Pure® 3-Factor Model Price/Earnings, Yield, Price/Book JPM BAC Wells Citi = Centroid Price/Book JPM BAC Citi UBS AXP MS Wells UBS AXP MS STT STT NTRS RJF NTRS RJF Value or Growth? Your Style Lens Makes a Big Difference for Bank of America, Citigroup, UBS, and Morgan Stanley View your favorite stocks & indexes at: < Style Scan >
  • 13. Style Index Returns for the 3 Years Ending 2010 2 1 0 Russell 200 Value Growth Surz Style Pure® Large Cap 0.6 Value Growth Core -1 -1 -2 -2.4 -3 -4 -5 -6 -7 -8 -9 -6.5 -7.9 A value manager that “Wins” against one index could easily “Lose” against the other index. Ditto for growth. What does this manager actually do?
  • 14. Summary: Good Building Blocks for Custom Benchmarks Mutually Exclusive  Exhaustive  Dependable classification design  Regular rebalancing, more frequently than annual  14
  • 15. Winners and Losers What does this manager do? Custom Benchmark Does he/she do it well? 15
  • 16. Truths 1. Peer Groups all have a little known bias called “Classification Bias.” 2. Statistical significance can be achieved over short periods of time, but not with regressions (“alpha & beta”). Use Hypothesis Testing instead. 16
  • 17. 17
  • 18. CFA Institute Benchmark Committee Report •Be wary of peer groups Classification, composition & survivor biases •Use custom benchmarks instead 18
  • 19. The Wait: Number of Years to Achieve Significance Regardless of the Benchmark, It Takes Decades to Exhibit Statistical Significance 160 140 120 100 80 60 40 20 0 A Little Skill Good Skill # of years = (1.35/IR)2 Great Skill 19
  • 20. Test the Hypothesis “Performance is Good” using Virtual Peer Groups (VPGs): Transforms a Custom Benchmark into a “Peer Group” Simulator Benchmark Construction Rules Portfolio Opportunities 20
  • 21. Style Universes for 2010 21
  • 22. It’s all about the Future Attribution: Strengths should continue and failures are being corrected 22
  • 23. Truths Knowing why (attribution) is the key, but if the benchmark is wrong all of the analytics are wrong. 23
  • 24. Sample Fund Lg Value Core Custom Attribution Lg Growth Fund Return 24
  • 25. Evidence Sortino Research Excess Omega using “best” style analysis persists: published in Pensions & Investments  Desired Target Return (DTR) Alpha can be and actually has been achieved  The Trone Challenge   Procedural Prudence vs Substantive Prudence: Common vs “Best” Practices. 2005 performance contest 25
  • 26. Truths 1) Custom benchmarks best define what a manager does. Building blocks (indexes) matter a lot 2) Hypothesis testing reveals real success or failure. Statistical significance can be achieved over short periods of time by simulating the opportunity set. 3) Knowing why (attribution) is the key, but if the benchmark is wrong all of the analytics are wrong. 26
  • 27. Fine: How Can I Use This? Demand the Best:  21st Century investment manager due diligence. Always change a losing game. (DOL and NASAA fiduciary requirement)  Portfolio optimization that blends skillful active with passive where there is no skill. 27
  • 28. Allocating (Indexes) to Skillful Managers (Benchmarks) INTEGRATE Avoid the 4-corner solution Large Value Small Value Large Growth Small Growth 28
  • 29. Coordination is the Key CORE is the Locksmith 1. Find Skill by Looking Everywhere, not Just Style Corners. Use 21st Century tools. 2. Allocate to Skill to Maintain Diversification (Optimize). 29
  • 30. What will it take? Advisors must demand that new & improved tools are used by their due diligence providers. If we don’t really care, the Loeper school makes the most sense – don’t waste the money. 30
  • 31. We’re all hardwired to resist change •Attachment bias: Continued reliance on an approach for emotional reasons, such as “We’ve always done it this way.” •Cognitive dissonance: The challenge of reconciling two opposing beliefs. •Confirmation bias: The natural tendency to accept any information that confirms preconceived position and to disregard information that doesn’t support this position. •Overconfidence: In combination with confirmation bias, the placement of too much emphasis on one’s own abilities. •Status quo bias: The tendency to do nothing, even when action is in order. •Laziness: Change takes effort. 31
  • 32. The Folly of Common Practice Common practice sometimes defies common sense. 32
  • 33. Bibliography http://www.ppca-inc.com/WhitePapers/white_papers.htm http://www.ppcainc.com/Commentaries/Commentaries.htm 33
  • 34. Questions Please  The Issues: Schools of Thought  Performance Evaluation: Benchmarking and Significance Testing  Attribution: Getting Whys  Proof of Better Living Through Science  Integration: Portfolio Construction 34