Tuesday, January 24th, 2012
an independent review

The previous research puzzle stressed the importance of hearing (and truly considering) alternative points of view before making an investment decision.the research puzzle | The title was “point counterpoint.”  This one proceeds on to examine how investment organizations (and buyers of investment services) can benefit from having an independent review of their processes.

Reviews by outsiders come into play in a variety of ways.  Sometimes their use is enforced, as when independent monitors or consultants are required as a part of a regulatory action,the research puzzle | The Global Research Analyst Settlement had both; here’s a PDF of my series on it. but those are unusual cases.  Certain kinds of external reviews (such as third-party valuations, assessments of trading costs, and specialized performance attribution services) are common in the business, but those of investment process are relatively rare.

Organizations that are subject to due diligence reviews as a part of selling their services tend to see that as the ultimate check of what they are doing.  But while some of that due diligence is in-depth and insightful, much is merely check-the-box and perfunctory.  Plus, the outcome of the review is not intended to improve the process, just to make a decision about it.  Something more is needed.

Granted, the culture at some organizations leads to regular examinations of the “how” as well as the “what.”  But that’s unusual.  Too often a strategy session that’s supposed to be about process ends up with a discussion about pressing investment decisions.  It is very hard to step away from them long enough to take a thorough look at how decisions are made.  It’s not what investment professionals are good at or interested in, so it doesn’t happen often.

And the same is true for those who are charged with making decisions about investment managers and other service providers.  Sometimes it’s because there is a choke point of information.  The classic example involves the members of the boards of mutual funds.  While they are supposed to be independent of the asset managers that they use (and, in fact, should be making judgments about them), the information that they are given comes from the asset managers themselves.  Instead, their primary inputs ought to be analyses from independent sources with unfettered access.

A very destructive tendency is the inclination to make decisions based upon the actions of a peer group.  I recently had an exchange with the officer of a foundation who is involved in a major review of its approach.  As I told him, “the biggest problem is that they [such reviews] often become an exercise in benchmarking.”  While it’s important to have some idea of what others are doing, the findings become behavioral anchors that impede real progress.  (If you are interested in issues faced by those who buy investment services, check out The Prudent Fiduciary Digest.tjb research | The first issue of the free newsletter will be published soon; you may sign up via this link.)  An independent review must take an expansive look forward, not a restrictive look backward.

For thoughts about how asset managers can also benefit from such a review, check out the latest piece by Mariko Gordon of Daruma Asset Management.On Daruma’s Watch | Gordon’s newsletters are always entertaining and informative.  As she indicated, “when you’re in the trenches, it can be hard to shift perspective and see the bigger picture.”   So Daruma had someone to do a review and found much of value.  The money quote:  “Disinterested parties bring a detached perspective that is impossible to come by in-house.”

While I’ve never called myself an “investment process auditor” (the description used by Gordon) and often am involved in a more comprehensive look at an organization, this is the core of what I do for a living.  So, let it be clear that I’m talking my own book when I say that research firms, asset managers, institutional investors, RIA firms, and other entities need to regularly examine how they do what they do.  It helps to have someone there with fresh eyes to see things that you may not.

If you don’t want to hire me, hire Dan (who helped Daruma) or someone else who can take an objective look at what you are doing.  You’ll find pieces that have drifted out of place.  And you’ll be become better prepared for the next due diligence review that you have, the next presentation of your ideas, the next market spasm that puts your process under stress, and the next twist of the investment world.