Monday, December 5th, 2011
one tremendous tell

The general theme of this slowly-evolving series of postings on investment stylesthe research puzzle | This PDF updates with links and descriptions as each posting is completed. is that an important part of the process of due diligence is finding different angles from which to view a strategy or an asset manager.

Anyone can look at past performance.  The more quantitative among us can also debate the evidence displayed by a variety of statistical measures, thinking that we’ll find a key to unlock the code as to which managers are good and which are not.  All of that has worth in the analytical process, but it’s also all backward-looking, and is almost always given too much weight by decision makers.  It is in the interplay between the quantitative measures (easy to get and generally cheap) and the qualitative aspects of due diligence (unfortunately, time-consuming and expensive) that the real insights are found.

As previous postings have indicated, often you are trying to look beyond entrenched categorization schemesthe research puzzle | I have written on this topic before, including one look at “where we draw the lines.” to see things that others don’t, but that’s not always the case.  Take, for example, the financials.  If you are evaluating equity managers right now, that sector is a tremendous “tell” as to how a manager operates.

You start with a treasure trove of historical information.  Look at a manager’s last seven years of investment in the sector.  How did the overall exposure to the sector vary?  What kinds of companies were in the portfolio?  Which risks were taken and which risks were avoided?  Is there evidence that the manager’s style as executed matched the style as promoted?  How did the approach to the financials change across that tumultuous period?

A simple overlay of the percentage of the S&P 500 represented by financials over timeBespoke Investment Group | Bespoke periodically publishes this look at sector weights — check out the change in the financials. versus that of the manager’s portfolio should give some clues.  Which one leads the other?  How big is the divergence at any point in time?  The sub-sector and security weights will also help you to see how active a manager really is and what circumstances trigger trades.

I could go on with the questions.  The purpose of them is to gain an understanding of how a manager thinks and operates.  That will tell you more about what will happen in a variety of environments going forward than any of the quantitative measures, although the migratory paths of the various statistics give lots of hints how manager behavior has evolved in the past and how it might in the future.

Obviously, a manager’s answers to your questions must be judged in terms of his or her stated goals.  Those whose processes chiefly rely on technical or quantitative analysis have different considerations than those with fundamental approaches, and every equity style category (growth, value, momentum, sector rotation, etc.) has its own traps.  With that in mind, what happened and why?

But enough looking backward.  The reason for focusing on the financials is not just because of their checkered past but because they present unique issues going forward, especially (but not exclusively) the banks.  So, if you are looking at a quantitative manager, how have the algorithms been adjusted over time?  What triggers exposures now?

For fundamental managers, you should look at how resources have been altered.  Sectors that have done poorly often have had changes in personnel and staffing levels may have been cut (along with outside research services that specialize in the area).  The performance patterns you could see might be different simply due to structural choices at the management firm.

One thing to watch out for is poorly-informed bravado, since sweeping generalizations about future prospects and intrinsic value are often made despite a distinct lack of critical information given the lack of transparency at many financial firms.  The bottom line is that how an investment manager approaches what is known versus what is unknown regarding the financials is an incredible indicator right now.  Putting them through the ringer by way of pointed questions about the sector will give you more of what you need to know about them than almost anything else you could do.