February 11, 2011 WebinarThe History Of Manager Due Diligence    And Where We Went Wrong Not Much Has Changed, But it Shou...
The craft of delivering solutions60s       70s           80s             90s          2000s          Schlepper/    Manager...
It’s a Bad Joke…each money manager has ready stories about other moneymanagers with low alphas who snatched clients throug...
Agenda   The Issues: Schools of Thought   Performance Evaluation: Benchmarking    and Significance Testing   Attributio...
Schools of ThoughtDave Loeper, President and CEO of Finance WareInsufficient value added given the time, energy and money ...
Winners and Losers:Use the right tools to addressthe 2 central due diligence questions:What does this manager do?         ...
Truths1.   An index is NOT a benchmark, except for index     huggers and indexers. Tracking error is neither risk nor     ...
Dr. William F. Sharpe“It is desirable that the selected asset classes  be:Mutually Exclusive (no class should overlap wit...
Creating Mutual Exclusivity“Refining Core-Satellite Investing”,Journal of Performance Measurement, Fall 2010   9
Surz Style Pure® Indexes  Core behaves differently than value and growth            Large      Middle        SmallValueCor...
Value-Growth Classification  Price/Earnings                       Price/Book     Earnings are a Flow                 Boo...
Whose Style is it Anyway?                Classifying Financials in Q2, 2010Surz Style Pure® 3-Factor Model                ...
Style Index Returns for the                    3 Years Ending 20102        Russell 200                      Surz Style Pur...
Summary: Good Building Blocks forCustom Benchmarks Mutually Exclusive Exhaustive Dependable classification design Regu...
Winners and LosersWhat does this manager do?     Custom BenchmarkDoes he/she do it well?                             15
Truths1.   Peer Groups all have a little known bias called     “Classification Bias.”2.   Statistical significance can be ...
17
CFA Institute             Benchmark Committee Report•Be wary of peer groups Classification, composition & survivor biases•...
The Wait:Number of Years to Achieve SignificanceRegardless of the Benchmark, It Takes Decades to Exhibit Statistical Signi...
Test the Hypothesis “Performance is Good” usingVirtual Peer Groups (VPGs): Transforms aCustom Benchmark into a “Peer Group...
Style Universes for 2010                           21
It’s all about the FutureAttribution: Strengths shouldcontinue and failures are beingcorrected                            ...
TruthsKnowing why (attribution) is the key, but if thebenchmark is wrong all of the analytics are wrong.                  ...
Sample Fund        Lg        Value              Core                     Custom Attribution  Lg GrowthFund Return         ...
EvidenceSortino Research Excess Omega using “best” style analysis  persists: published in Pensions &  Investments Desire...
Truths1) Custom benchmarks best define what a manager does.      Building blocks (indexes) matter a lot2) Hypothesis testi...
Fine: How Can I Use This?Demand the Best:   21st Century investment manager due    diligence. Always change a losing game...
Allocating (Indexes)to Skillful Managers (Benchmarks)INTEGRATE         Avoid the 4-corner solution        Large           ...
Coordination is the Key  CORE is the Locksmith1. Find Skill by Looking Everywhere, not Just Style   Corners. Use 21st Cent...
What will it take?Advisors must demand that new & improved toolsare used by their due diligence providers.If we don’t real...
We’re all hardwired to resist change•Attachment bias: Continued reliance on an approach foremotional reasons, such as “We’...
The Folly of Common PracticeCommon practice sometimes defies common sense.                                                ...
Bibliographyhttp://www.ppca-inc.com/WhitePapers/white_papers.htmhttp://www.ppca-inc.com/Commentaries/Commentaries.htm     ...
Questions Please   The Issues: Schools of Thought   Performance Evaluation: Benchmarking    and Significance Testing   ...
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Investment Manager Due Diligence

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The History of Investment Manager Due Diligence: Where we Went Wrong and Why

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Investment Manager Due Diligence

  1. 1. February 11, 2011 WebinarThe History Of Manager Due Diligence And Where We Went Wrong Not Much Has Changed, But it Should Ron Surz, CIMA, MS, MBA The Dark Ages President, PPCA Inc President, Target Date Solutions (949)488-8339 Ron@PPCA-Inc.com 1
  2. 2. The craft of delivering solutions60s 70s 80s 90s 2000s Schlepper/ Manager Asset Trusted Performance Selection and Allocation Advisor Reports Due DiligenceThe craft of manager due diligence60s 70s 80s 90s 2000sIndexes Peer Blended Indexes & Custom Peer Groups Groups
  3. 3. It’s a Bad Joke…each money manager has ready stories about other moneymanagers with low alphas who snatched clients through clevermarketing. Professor Meir StatmanI have never met a money manager who has performed belowmedian.Every manager wins against the right benchmark.We cannot change what we tolerate. The Madoff mess wasenabled by lax due diligence. 3
  4. 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. 5. Schools of ThoughtDave Loeper, President and CEO of Finance WareInsufficient value added given the time, energy and money to domanager due diligence right. The potential benefits of managerdue diligence are outweighed by the costs.Behavioral Finance Professor Meir Statman, What investorsWantInvestors demand active managers because they want to havefun, and they’ll pay extra for it. It’s similar to diners choosingfancy expensive restaurants.Dr. Frank Sortino, The Sortino Framework for ConstructingPortfoliosOptimize around talent by integrating active with passive. Useactive where you find skill, and passive where you don’t. 5
  6. 6. Winners and Losers:Use the right tools to addressthe 2 central due diligence questions:What does this manager do? IndexesDoes he/she do it well? Peer Groups 6
  7. 7. Truths1. 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. 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. 9. Creating Mutual Exclusivity“Refining Core-Satellite Investing”,Journal of Performance Measurement, Fall 2010 9
  10. 10. Surz Style Pure® Indexes Core behaves differently than value and growth Large Middle SmallValueCoreGrowth Surz Morningstar 1986 1997 2010 10
  11. 11. Value-Growth Classification Price/Earnings Price/Book  Earnings are a Flow  Book Value is a Stock Variable (Current) Variable (Historical Accounting)  Book values of some large banks are grossly overstated in this financial crisis“Becoming Style Conscious”, Journal of Investing, Fall 2010 11
  12. 12. Whose Style is it Anyway? Classifying Financials in Q2, 2010Surz Style Pure® 3-Factor Model = CentroidPrice/Earnings, Yield, Price/Book Price/Book JPM JPM BAC BAC Wells Wells Citi Citi AXP UBS UBS AXP MS MS STT STT NTRS NTRS RJF 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. 13. Style Index Returns for the 3 Years Ending 20102 Russell 200 Surz Style Pure® Large Cap1 0.6 Value Growth Value Growth0 Core-1 -1-2-3 -2.4-4-5-6-7 -6.5-8 -7.9-9 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. 14. Summary: Good Building Blocks forCustom Benchmarks Mutually Exclusive Exhaustive Dependable classification design Regular rebalancing, more frequently than annual 14
  15. 15. Winners and LosersWhat does this manager do? Custom BenchmarkDoes he/she do it well? 15
  16. 16. Truths1. 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. 17
  18. 18. CFA Institute Benchmark Committee Report•Be wary of peer groups Classification, composition & survivor biases•Use custom benchmarks instead 18
  19. 19. The Wait:Number of Years to Achieve SignificanceRegardless of the Benchmark, It Takes Decades to Exhibit Statistical Significance 160 140 120 100 80 60 40 20 0 A Little Skill Good Skill Great Skill # of years = (1.35/IR)2 19
  20. 20. Test the Hypothesis “Performance is Good” usingVirtual Peer Groups (VPGs): Transforms aCustom Benchmark into a “Peer Group” Simulator Benchmark Construction Rules Portfolio Opportunities 20
  21. 21. Style Universes for 2010 21
  22. 22. It’s all about the FutureAttribution: Strengths shouldcontinue and failures are beingcorrected 22
  23. 23. TruthsKnowing why (attribution) is the key, but if thebenchmark is wrong all of the analytics are wrong. 23
  24. 24. Sample Fund Lg Value Core Custom Attribution Lg GrowthFund Return 24
  25. 25. EvidenceSortino Research Excess Omega using “best” style analysis persists: published in Pensions & Investments Desired Target Return (DTR) Alpha can be and actually has been achievedThe Trone Challenge Procedural Prudence vs Substantive Prudence: Common vs “Best” Practices. 2005 performance contest 25
  26. 26. Truths1) Custom benchmarks best define what a manager does. Building blocks (indexes) matter a lot2) 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. 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. 28. Allocating (Indexes)to Skillful Managers (Benchmarks)INTEGRATE Avoid the 4-corner solution Large Large Value Growth Small Small Value Growth 28
  29. 29. Coordination is the Key CORE is the Locksmith1. Find Skill by Looking Everywhere, not Just Style Corners. Use 21st Century tools.2. Allocate to Skill to Maintain Diversification (Optimize). 29
  30. 30. What will it take?Advisors must demand that new & improved toolsare used by their due diligence providers.If we don’t really care, the Loeper school makes themost sense – don’t waste the money. 30
  31. 31. We’re all hardwired to resist change•Attachment bias: Continued reliance on an approach foremotional reasons, such as “We’ve always done it this way.”•Cognitive dissonance: The challenge of reconciling two opposingbeliefs.•Confirmation bias: The natural tendency to accept anyinformation that confirms preconceived position and to disregardinformation that doesn’t support this position.•Overconfidence: In combination with confirmation bias, theplacement of too much emphasis on one’s own abilities.•Status quo bias: The tendency to do nothing, even when action isin order.•Laziness: Change takes effort. 31
  32. 32. The Folly of Common PracticeCommon practice sometimes defies common sense. 32
  33. 33. Bibliographyhttp://www.ppca-inc.com/WhitePapers/white_papers.htmhttp://www.ppca-inc.com/Commentaries/Commentaries.htm 33
  34. 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

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