Written by:  Steve Luchko

At times, the database and ranking system created by Morningstar, an investment research company often relied on by both retail investors and institutional investors alike, is imprecise in describing the philosophy of a mutual fund or exchange traded product. This imprecision occurs for a multitude of reasons, but routinely it is due to Morningstar’s attempt to use a single index or incorrect index as a representative performance benchmark for a fund’s investment style.  Portfolio managers of fixed income funds, for example, often prefer (and often correctly so) to incorporate a blend of indices into their benchmark.  But a blend throws the proverbial monkey wrench into the Morningstar database. Therefore, Morningstar simplifies things by often using the single index, and in doing so, decreases the accuracy and efficacy of its database. A truly accurate view of an investment, then, requires looking beyond the databases and digging deeper.

The mis-categorization of a mutual fund or exchange traded product has the potential to create perverse rewards for a collection of fund managers at the expense of the investor. If everyday investors only rely on the rankings of databases that have seemingly binary outputs (merely “good” or merely “bad”), more capital will flow to “good” and a fund company will be rewarded with more assets under management, which translates into more fees. (Typically, though, there are size limitations to a fund’s success as assets under management growth can limit performance in certain asset classes; this is especially true within subcategories of fixed income.) Consequently, this phenomenon creates great opportunities for an advisor to find a diamond in the rough that was deemed “bad” by the databases.

An advisor should not use clients’ capital to chase “good” investment products and avoid “bad” products but should allocate capital in probabilistic situations into the future and obtain a fair rate of return for the amount of appropriate risk being taken. Forget “good,” forget “bad,” but always invest in simple and shrewd. Often it is as easy as taking the time to ask the right questions to look beyond the database.  This is why you should have an advisor who can communicate directly with a fund’s portfolio manager.  But how does one begin to connect and investigate?

Typically, an advisor should put forward to the portfolio manager a proposal to complete a Due Diligence Questionnaire (“DDQ”). The DDQ helps flush the system and allows the advisor to minimize behavioral assumptions. The goal of a DDQ, or any checklist, is to avoid obvious and predictable errors, like wrongly supposing the database is 100% clear-cut. Checklists are not emotionally involved and are not over confident like us humans. The advantages of obtaining portfolio managers’ responses in written form are twofold: 1) Wall Street investment products are often sold and not bought, and a written response is less likely to have an affirmative tone and, from my experience, will be less opinionated, and 2) Writing identifies the personal limits of one’s understanding of a topic (i.e., writing reduces conjecture).

Below is a sampling of the questions that should be used when vetting a third-party portfolio manager. The checklist should include approximately 50 questions in aggregate and should be tailored to a specific asset class.

  1. Which individuals (either employees of the firm or external investors/academics) were most influential in shaping the current philosophy and process?
  2. How do you describe, quantify and evaluate risk? What methods are used for measuring, monitoring and controlling portfolio risk?
  3. How many dollars are held by your three largest clients within the strategy? What happens if those three owners decided to sell on the same day? Clarify the domino effects and potential impact to net asset value.
  4. What are your competitive advantages and limitations? List any evidence that leads you to believe your investment team possesses a greater level of skill than its peers. Based on your beliefs and edge, where do you aim to add value (e.g., security selection, sector weightings, country selection, currency, market timing, trading, multiple strategies, etc.)?
  5. What economic and market conditions pose the greatest risk to the effectiveness of your investment process?
  6. Describe the research methods and sources through which information on an investment idea is gathered, including any external support (e.g., company management, Wall Street analyst, third party research, talking to customers or suppliers, etc.)? Do your analysts visit companies/issuers?
  7. Describe the financial modeling of investment ideas, including a high level description of the methodology, systems/software used, time horizon over which a company’s financials are modeled, and valuation metrics used.
  8. Provide an example of an investment decision (i.e., a specific security, sector or theme) made in the past 5 years that you regret. What was the original investment thesis and what went wrong? Looking back, what, if anything, would you have done differently?
  9. Provide the bear thesis on the top two largest holdings within the fund.
  10. Why do you think your investment philosophy will be successful in the future?

Finally, just because the questions are answered on the DDQ does not mean the investment is a sound one or an advisor should believe the investment story indiscriminately. The central idea is that one’s investment process should not be based on a database or story (everyone on Wall Street has a great story), but rather on an evidence-based process that demonstrates robustness over time. The DDQ is a great tool, but only one of the first steps in the investment selection process.

If you have any questions about the investment process used at Agili, please feel free to contact your Financial Strategist or a member of our Investment Team.