Due dilligence

Tipple.fm Page 46 Monday, May 17, 2010 3:16 PM

Avoiding the Pitfalls: Best Practices in
Manager Research and Due Diligence
Brian Tipple
Chief Investment Officer, Equities
Russell Investments
London
Disappointment with investment manager selection can be reduced by considering the
tangible “4 P’s” (people, process/philosophy, portfolios, and performance) and the intangible
“4 P’s” (passion, perspective, purpose, and progress). In addition, strategic-partner risk can
be better understood with a thorough due diligence program that identifies operational,
trading, and regulatory risks.
❚■❚

ussell Investments has spent more than 40 sell funds. This evolution in thinking required that
R years seeking to identify what differentiates
skillful managers and their future fund outperfor-
we look deeper into the business practices of money
management firms and attempt to minimize the
mance from other active management participants. inherent strategic-partner risks. Historically, we
The purpose of this presentation is to describe our have experienced about a 15 percent annual turn-
manager research process and, in particular, the over rate among money managers in our funds. This
way in which we evaluate the assumed strategic- rate means that any manager we hire will likely
partner risks when we hire a money management represent a long-term relationship that must be
firm for our funds business. evaluated at a strategic level. In partnerships such
as these, both parties should recognize their mutual
Evolution of Manager Research obligations as well as potential business risks. For
these reasons, we introduced a formal manager
Process oversight program.
In 1969, Russell Investments hired its first research
analyst in charge of evaluating managers. During Alpha Engine Focus
the next 510 years, we expanded our manager
The original focus of our manager research process
research capabilities and began to develop a system-
was on the Old 4 P’s: people, process/philosophy,
atic process for evaluating money management
portfolios, and performance. We still consider the
firms. In doing so, we developed what we now refer
Old 4 P’s an important part of our manager research,
to as the “Old 4 P’s” to help guide the conduct of our
so it is worth briefly reviewing each “P.”
manager research meetings.
As our thinking evolved, we came to recognize The Old 4 P’s. We begin with people because
that although our approach was systematic, it did investment management is a people business. It is all
not necessarily identify all of the key success factors about strong individual investors or a team of strong
that we had observed at successful money manage- investors that is expected to generate the returns that
ment firms over time. As a result, we developed the clients expect. We then focus on a management
“New 4 P’s,” which are intended to complement our firm’s investment process or philosophy because
traditional approach as well as to identify those understanding how the process works and how it
characteristics we believe improve the prospects for aligns with the people involved in the organization
better investment outcomes in the future. is critical. Next, looking inside portfolios allows us to
By 2000, we began considering not only risk and determine whether the portfolio approach that a
return in the traditional sense but also the need to manager describes matches reality. Finally, we con-
better understand and control the relationship risk sider performance, from the perspective of under-
inherent in the managers we hired to manage Rus- standing how past performance patterns match
what we have observed from portfolio trading deci-
This presentation comes from the 2009 CFA Institute European sions and what we have heard from the investment
Investment Conference held in Frankfurt on 21–23 October 2009. manager or investment management teams.

46  JUNE 2010 ©2010 CFA Institute  cfa pubs .org


Avoiding the Pitfalls

The Old 4 P’s outline a framework for structur- he not only loves the business; he lives the business.
ing our meetings and discussions with money He has been incredibly successful. Yet every day
management firms. presents a new challenge for him, and that keeps
But the Old 4 P’s do not necessarily allow us to him interested and driven to excel.
evaluate the intangibles that we eventually have Although passion is largely an intangible factor,
come to believe are part of key success factors. We we also evaluate other factors in this category, such
believe these success factors help improve our as employee interaction, the firm’s incentive struc-
chances of identifying skillful managers in whom ture, and personnel turnover.
we have high confidence about the probabilities of ■ Perspective. Managers with perspective
their future outperformance. know the limits of their capabilities and, generally,
possess strong sell disciplines. In general, it seems
The New 4 P’s. To better identify the essential
that many investment management firms struggle
intangibles, we developed the New 4 P’s as a com-
with this critical part of a successful investment
plement to our original manager research approach.
process. The key market drivers of a firm’s perfor-
They are passion, perspective, purpose, and prog-
mance results and the time horizon of those drivers
ress. The New 4 P’s have allowed us to categorize
are often not broadly understood. For example, an
the characteristics of firms that we believe improve
international investment manager we knew called
the possibilities of identifying superior managers.
his clients after an amazing two-year run and told
■ Passion. Passion is a powerful emotion. them it was time for him to give back their money.
When we sit down with investment managers, we His research team was unable to come up with
can observe passionate behaviors, not necessarily suitable investment ideas, and as a result, he
from the volume of their communications or from thought he was likely to underperform for a period
the specific words they choose but from their inten- of time. He made this recommendation more than
sity. We are looking for highly motivated and once, and his timing tended to be quite accurate.
intensely competitive managers who are focused on This manager’s behavior indicated to us that he had
excellence if not perfection. perspective. He understood not only what he could
As an example of passionate behavior, consider do and how his clients would benefit but also when
the typical day of a manager we have known for his investment approach was likely to enter a period
almost 20 years. of softer relative performance.
At about 5:00 a.m., the alarm clock goes off. The When evaluating perspective, we consider evi-
manager rises and goes to the office next to his dence of a strong sell discipline but we also consider
bedroom where, throughout the night, his specially how managers respond to both good and bad per-
programmed computer has been gathering infor- formance periods. We are interested in the way they
mation about developments in the Asian markets. construct their portfolios and how they treat mis-
He focuses on certain stock-specific issues, such as takes. Many managers, when dealing with a stock
earnings reports, but because he manages a global that generates disappointing results, simply sell the
product, he is also looking for broader geographical stock and move on. But managers with perspective
insight as well. After an hour or so, he has breakfast analyze why the decisions they made did not work
with his wife. He then arrives at his office around out and try to learn from the experience.
8:00 a.m., where his team has been working for more Some managers with perspective extend their
than an hour and preparing to discuss any news core competencies into new areas, but they also
that might be relevant to the firm’s investment have the discipline to limit the amount of money
positions. From then until about 5:00 p.m., the man- they are willing to manage because they understand
ager involves himself in classic fundamental the limits of their investment strategy’s capabilities.
research—speaking with company managements, ■ P u r p o s e . Thomas Huxley once said,
suppliers, competitors, world leaders, and so on. At “Patience and tenacity of purpose are worth more
about 5:00 p.m., he typically heads to the golf course than twice their weight in cleverness.” We think
for about 90 minutes worth of practice at the driving Huxley sums up our approach to purpose fairly
range or putting green before heading home to well. Managers with purpose are committed to their
enjoy dinner with his family. After dinner, he is back investment philosophy. These managers are incred-
in his home office until he turns off the lights around ibly protective of their competitive advantage. The
midnight. He seemingly gets by comfortably on five manager I mentioned earlier who recommended
hours of sleep, and then the day starts over again. that he give his clients’ money back demonstrated
Not every successful manager shares these purpose around his investment process. He was
behaviors, but this manager demonstrates to us that willing to wait until he thought his approach would

©2010 CFA Institute  cfa pubs .org JUNE 2010  47


CFA Institute Conference Proceedings Quarterly

be successful again. When that manager went back Alpha Engine Focus and the New 4 P’s.
to his clients to tell them it was time to invest again, We believe that the New 4 P’s allow us to focus more
he had built up so much credibility that his clients on what we have observed to be characteristics of
were very willing to take his advice. He had shown successful firms. The Old 4 P’s still provide an
that through the investment cycle he maintained a excellent framework for meeting and beginning the
disciplined and focused investment approach and analysis of money management firms, but we are
held himself accountable for his decisions and per- convinced that the intangibles embodied in the
formance of the portfolio. New 4 P’s better describe the key elements of the
When evaluating purpose, we consider several most successful money management firms over
time. The ideal firm, which is only an aspiration,
factors. Firm structure is important. Generally,
has the Old 4 P’s in abundance. But managers in
managers who have large personal stakes in their
whom we have the highest confidence will score
firms are often the most committed to achieving
well in the New 4 P’s.
successful outcomes for clients. Idea generation is
another factor of great importance. We like to
understand how the firm is managing ideas from Investment Manager Oversight
all members of the team and how these ideas are Program
incorporated in the portfolio. We also evaluate staff Our investment manager oversight program uses
training, individual workloads, and how roles and specific objectives, a risk-based approach, and
responsibilities are assigned within the team. selection and monitoring processes to manage
■ Progress. One characteristic of managers strategic-partner risk.
who are willing to progress or evolve is that they
tend not to be very comfortable with the status quo. Objectives of the Program. The first objec-
One very successful manager we know is incredibly tive is to improve our manager decision-making
talented and has generated a remarkable track ability. As a proper fiduciary, we at Russell Invest-
ments must possess a detailed understanding of the
record for more than 20 years. Yet, when we visit
risks inherent in the decisions we make on behalf of
him, it is difficult to tell from his demeanor whether
clients. Therefore, understanding our strategic-
his portfolio is performing well or poorly because
partner risks helps us do a better job of fulfilling our
he never seems pleased or contented. Despite his
fiduciary obligations.
long-term success, he is never comfortable with
Furthermore, by communicating with manag-
what is happening at that moment and is always ers on a frequent basis and sharing with them our
worried about what could happen next. Managers global perspective on best practices about compli-
such as this one are often quite comfortable with ance, trading, operations, and business structure,
change. They recognize that markets evolve and we help to improve our money managers’ under-
that they need to adapt to remain relevant and standing of best practices. Most importantly,
effective. But besides seeing that they are willing to though, we strive to protect our clients’ interests.
change, we are also interested in how they change. Those of us who invest based on anticipated
We want to know how their investment process outcomes on a daily basis do not enjoy negative
evolves over time, how they manage changes in surprises. This program is intended to reduce the
their investment teams, and how they adapt their opportunities for such surprises, even if it cannot
thinking to new information. eliminate them entirely.
We also evaluate how a management firm
Risk-Based Approach. Through our risk-
approaches its ongoing R&D efforts. It is always a bit
based approach, we target compliance, operations
surprising when managers call to tell us they are
and trading, and organizational structure (includ-
thinking of making a change to their investment ing technology) so that we can better understand the
process and would like our opinion. Our philosophy capabilities of our investment management part-
is that managers know best what is likely to be an ners in these three areas.
effective change to their investment process. We We are also interested in a manager’s perspective
expect that managers will tell us how they have about these risks. For example, compliance practices
incorporated their latest research into improving are very important to us, and our approach is
future investment results. To us, these are managers designed to quickly determine whether a prospec-
who understand the three critical parts of the New 4 tive manager also thinks it is important. Similarly, we
P’s but also understand how to progress in the most want to understand the level of importance money
constructive way. managers place on the control structures within their



Avoiding the Pitfalls

investment firm and whether those control struc- ager. The qualitative aspect of our review is critical
tures are appropriate for the firm’s size, point in the because an effective oversight program is much
life cycle, and sophistication of its product spectrum. more than just a numbers exercise. We believe that
We conduct two types of review. The first review face-to-face meetings are critical because we devote
considers policies and procedures from a global best time to the people who are responsible for these
practices perspective. It also includes a review of the important processes and practices, what roles they
firm’s regulatory requirements. The second review is perform, and how their experience and competence
narrower and focuses on such things as how the firm might affect our clients and us.
manages conflicts of interest, its code of ethics, gov- Among the potential red flags revealed by our
ernance, vendor oversight, and trade processes, as program, one of the most glaring is the lack of an
well as policies on best execution and use of soft independent, third-party audit. The lack of inde-
commissions. Our program is very similar to a State- pendent audits has often been a critical flaw that
ment on Auditing Standards (SAS) 70 Type 1 review. helped many of the so-called Ponzi-schemers per-
Once we engage with an investment management petuate their crimes. The quality of the third-party
firm and have a contractual relationship, we use audit and the reputation of the auditor is also an
more of a typical SAS 70 Type 2 review. important consideration.
Conflicts of interest also create a significant
Selection and Monitoring Process. As part opportunity for potential problems. For example, an
of our manager research process, we rank each man- affiliated trading relationship between an asset man-
ager we visit based on our confidence in his or her agement firm and its brokerage parent is a potential
ability to generate positive excess returns in the area of concern. Before we can be comfortable with
future as well as the stability of the firm’s contribu- such a relationship, we want to understand how that
tors or drivers of that expected outperformance. relationship works and how decisions are made
When a Russell portfolio manager identifies a man- around those trades. At a minimum, it is important
agement firm whose investment characteristics are that best execution testing procedures are in place
desirable in his or her fund, the manager oversight and regularly monitored by senior management.
team builds an initial questionnaire and sends it out Similarly, the existence of personal relationships
to the firm under consideration. It also conducts fur- between the investment firm and its vendors can be
ther research to prepare for an on-site visit, which we a cause for concern. Most firms have gifting policies
consider a critical aspect of the program. Following that are reviewed by compliance teams every quar-
an on-site visit, the manager oversight team reviews ter. We are trying to make sure that the relationships
its findings with the Russell portfolio manager. We between vendors and investment personnel are
also share our assessment with the respective money appropriate. We look carefully at personal trading
management firms. The oversight team then assigns procedures to ensure that a clear policy, consistent
the manager a risk rating of low, medium, or high, with best practices, is in place.
and the portfolio manager presents a new manager Finally, a firm’s governance and management
recommendation to our investment strategy commit- structures are critical. We want to understand the
tee. The committee evaluates the prospective man- firm’s reporting relationships, its structured flow of
agement firm from both an investment perspective information, and its separation of duties.
as well as a strategic-partner risk perspective.
Once we reach a contractual agreement with the
investment firm, we engage in ongoing monitoring. Case Studies
We send quarterly and annual questionnaires, and The following scenarios are based on a few actual
we conduct on-site reviews on a one- to four-year incidents that were revealed through our invest-
cycle, depending on the risk rating we have ment manager oversight program and should high-
assigned to the manager. Finally, we have midpoint light the value such a program can offer.
conversations with the firm to assess material
changes and examine how the firm has progressed Protecting Reputations. During an on-site
around the areas of risk that we have identified. review with a U.S. equity manager, an impending
regulatory action by the U.S. SEC was disclosed.
Areas of Concern. The critical reason for our Our manager oversight team immediately shared
manager oversight program is to protect our clients. this information with our manager research and
Fraud is currently among the greatest areas of con- portfolio management teams, who then contacted
cern. Although no program can prevent fraud the management firm directly to develop a better
entirely, we believe our approach reduces the understanding of the nature of the violation. We
chance that we will engage with a fraudulent man- then assessed the impact of the SEC action on the



CFA Institute Conference Proceedings Quarterly

manager’s business and investment process and The biggest Ponzi-like scheme to date that
ultimately decided to retain the firm. We immedi- occurred recently affected a large number of inves-
ately apprised our clients and representative boards tors for a staggering amount of money. Each of us
of the situation and the rationale of our decision. has now heard of Bernie Madoff’s crime and the
Being on-site helped us uncover a situation that significant black eye his situation has given the
could have been embarrassing for our clients and investment industry. As such, it has become increas-
us. It also allowed us to understand the risks iden- ingly important to adopt oversight programs to
tified by the SEC and put that risk in the context of help avoid such disastrous events in the future.
making a good investment decision. There are a number of important lessons we have
learned from reading about how Madoff is said to
Improving Manager Practices. The follow-
have run his business.
ing two examples show how our process can help
our managers improve their business practices. First, Madoff reportedly did not engage in third-
■ Case #1. During a prehire visit with an party audits, which should have raised a red flag
emerging growth manager, we found a material con- because, as was mentioned earlier, we believe that
flict of interest in the firm. One person was respon- third-party audits are critical to ensure that proper
sible for operations, trading, and compliance. checks and balances are in place. Furthermore,
Accordingly, we helped this firm identify ways to Madoff reportedly had no independent custodian.
separate its compliance function from its operations When a client’s account was opened, it was set up as
and trading. Ultimately, the firm retained a third- a brokerage account that apparently went straight to
party vendor to do its external compliance. Madoff’s own computer. As with third-party audits,
■ Case #2. During an on-site review of an independent custodians are a fundamental part of
emerging markets manager, we found that several safekeeping client assets. Finally, Madoff reportedly
of its processes were not consistent with what we did not welcome on-sight client visits at his office in
believed to be best practices. We had, however, very Manhattan. We believe on-sight, face-to-face visits
high confidence in the manager’s investment capa- are a critical requirement of an effective manager
bilities. The team was very small, and it lacked con- oversight program because it helps to understand
trols expertise. This firm was particularly lacking in what control programs are in place, the qualifica-
the area of regulatory compliance, an area of partic- tions for those who manage these programs, and a
ular focus for us. In this case, we shared our recom- firm’s attitude about these types of risks.
mendations with the manager and actively helped it
develop a suitable set of policies and procedures.
Conclusion
Russell Investments’ definition of manager research
Avoiding Fraud—Is It Really and proper manager due diligence has evolved and
Possible? will continue to evolve. Our focus not only remains
As with many other firms, our focus has long been on identifying future successful investment manag-
on excess return generation for clients and the risks ers but also emphasizes the importance of proper
associated with the investment process. But the num- manager due diligence. This focus is driven by the
bers of recent Ponzi-like scandals have dramatically desire to understand all potential risks—business
revealed the layer of risk associated with hiring an risk as well as investment risk. We believe the best
investment manager. Although it is impossible to practice for hiring investment firms places great
completely avoid fraudulent situations in the future, focus on these two important areas.
we believe steps can be taken that help maximize the
probabilities of avoiding such negative events. This article qualifies for 0.5 CE credits.



Q&A: Tipple

Question and Answer Session
Brian Tipple
Question: When you visit a Tipple: Yes. Those factors are number of managers who are our
manager on-site, do you prefer to why we do not look only at pas- strategic partners. Overall, how-
meet portfolio managers, the sion. Passion to us means a love ever, our manager hiring deci-
executive management, or both? for going to work every day and sions are driven by the alpha
for achieving excellence, but it proposition, and I think we do a
Tipple: Both. When our man- needs to be balanced by other good job balancing that against
ager research team visits, our pri- aspects of success. Overly pas- our desire to minimize strategic-
mary focus is on meeting the key sionate people may think they can partner risk.
investment decision makers as never be wrong. Yet, we all know
well as understanding the invest- Question: How long do you
that being wrong on occasion is
ment process. Ideally, we like to take to complete your due dili-
part of the investment business.
meet with all the members of the gence process for a new manager?
team, such as research analysts. Question: Do you put more
Tipple: It varies. Often, when
Often the executive teams can emphasis on the firm or on one
our research analysts meet with
help us understand how the firm person? Would you follow the
a firm, they quickly have a sense
structures incentive programs, person to a new firm?
of the key excess return drivers in
manages personnel changes, and Tipple: Because we believe the manager’s investment pro-
so on. These are important factors investment management is a busi- cess. Sometimes, this meeting is
in understanding where a firm fits ness in which talent lives within quite short and may be the last
within the context of the Old and the person, we place more empha- meeting with this manager for
New 4 P’s. sis on the individual than the firm. quite some time. Otherwise, a
When the oversight review Because we seek to identify those follow-up meeting may last
team visits a firm, the compliance investors with skill, we have fol- between two and three hours.
and operations members of the lowed managers and shifted fund With high-interest managers, we
manager’s team have an opportu- assets from one firm to another. may have another two to three
nity to shine. We have been told hour meeting before a formal rank
Question: Because you have de-
that this focus on business prac- is given. On the due diligence side,
emphasized the pursuit of alpha,
tices often gives the firm’s compli- our researchers typically spend
how do you balance your clients’
ance, operations, and trading three to four hours on-site with a
need for alpha against the cost of
teams a greater level of impor- firm. Although before that meet-
performing a due diligence
tance within the manager’s orga- ing, they will probably spend five
review of a new manager?
nization, even if only on a or six hours reviewing responses
temporary basis! Tipple: Let me be clear. Our to our questionnaire and prepar-
focus is still first targeted toward ing for the manager visit. There
Question: Do you find the New identifying talented individuals, are also usually follow-up tele-
4 P’s in firms of all sizes, or do so we are not de-emphasizing phone conversations to clear up
small firms have an advantage? alpha in our process. We do think, outstanding issues.
Tipple: Size is not critical; however, that we are comple-
Question: Do you believe that
people are. We see great people menting this alpha focus with a
the current incentive structure
with incredible skills who are necessary understanding of the
works well for the industry?
part of both large and small partnership risk as it relates to our
organizations. funds’ business. We have a ratio Tipple: I guess it depends on
of about 5 to 1 in which specialists how one defines the current incen-
Question: Can passion be focus on manager research versus tive structure. Overall, though,
dangerous? Can it lead to ex- manager due diligence. This ratio aligning incentives with client out-
cessive risk taking and a weak largely reflects the number of comes is what we try to do and
sell discipline? managers we research versus the what we think is best practice.


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