Investment Manager Due Diligence: What We Care About

By Peter Mustian, MBA | Principal & COO
By Zach Heath | Analyst

Over the last two decades, Innovest has met with hundreds of investment management firms and vetted thousands of products and strategies. However, very few investment products have met our rigorous standards for our clients’ consideration. In this article, we are sharing the key criteria we use in the due diligence process.

Innovest’s approach to due diligence of active investment managers focuses on understanding whether an investment manager’s strategy has an identifiable edge in adding value on a forward-looking basis.
Innovest utilizes both quantitative and qualitative information to find the best managers. Quantitative information refers to historical, absolute, relative and risk-adjusted investment performance, as well as expenses. Qualitative information refers to the investment manager’s organization, culture, personnel, philosophy and process and style. We want our clients to invest in managers and strategies that have consistent performance, but also those that have a sound team and philosophy to help navigate fluctuating market environments.

Identifying investment managers that have performed well historically is relatively easy. However, where we spend our time and add value is in the hard work of identifying the managers that were talented, not lucky, when building their track record, as well as assessing if the talent is sustainable. We do not believe that a computer can successfully choose managers that will outperform benchmarks going forward. We rely on our years of experience coupled with extensive due diligence to evaluate and select managers.

Our proactive and structured approach to vetting investment managers and products aids in the avoidance of performance chasing and high manager turnover. Preparation, extensive research and frequent discussion throughout our due diligence process provides confidence that our clients are exposed to the best-in-class investment managers and products.

Outlined below are a set of principles in our investment product due diligence process that we believe are important when evaluating asset management firms. Please note that there are always exceptions to each of the criteria set forth below:

• Ownership. We prefer privately held firms to public firms, because public firms must serve two sets of constituents, their investors and their shareholders, potentially resulting in conflicts.

• Ownership Distribution. We prefer widespread and meaningful equity stakes among the firm’s investment professionals. This ownership distribution helps to ensure team stability and may positively impact the alignment of interests with clients.

• Team Depth. We like deep, experienced investment and research teams. We believe even the stars within the investment management world require good teams around them.

• Business Focus. We usually favor firms that are focused exclusively on asset management, as opposed to investment banks, insurance companies, commercial banks or other diversified financial institutions. It has been our experience that most quality products come from firms that are focused on asset management.

• Strategy Focus. We tend to prefer firms that have a core competency and stick to it. When firms try to offer products in every asset category, often they have a lot of bad products; no firm is good at everything.

• Research Focus. We favor firms that focus primarily on bottom-up research and security selection, as opposed to top-down economic research.
  Performance. We evaluate past investment performance by reviewing the historical results and portfolio attribution. Particular attention is given to downside risk, beta to the appropriate index, alpha, time of recovery from losses and performance consistency. Style drift and sector bets are carefully examined.

• Portfolio Turnover. It has been our experience that better performing, and more consistent products/strategies exhibit lower frequency of portfolio sales and purchases. We believe low turnover may differentiate true investing, where fundamental analysis tends to pay off, from market timing/trading strategies, which are more costly and less consistently helpful.

• Capacity. We prefer to invest with firms that have demonstrated a willingness to close products to new investors before asset growth negatively impacts performance, especially outside of highly liquid stocks and bonds.
  Compensation. We favor firms that prioritize long-term, risk-adjusted performance when compensating investment professionals, as opposed to compensation schemes that emphasize beating the index each year.

• Manager Investment. We prefer investment products where the manager has a significant amount of his/her own money invested alongside other investors in the strategy.

• Expenses. All else equal, we strongly prefer products with below-median expenses. We evaluate expenses on a continuous basis.