Manager Due Diligence—Key Questions to Ask Before Investing

Many wealth advisory firms use third-party investment managers to provide a range of investment strategies for their clients. This is because asset management is a full-time job; it would be difficult for wealth advisors to be experts in all asset classes and investment strategies while still providing the planning, tax, and other services that are important for comprehensive wealth management.

For advisors who use external managers, identifying and vetting high-quality managers is one of the most important ways that they add value for clients. As a result, advisors need a process for filtering and selecting asset managers—in other words, they need a manager due diligence process.

BDO Wealth Advisors’ investment team shares its perspectives on effective manager due diligence. We also outline some of the key questions that wealth advisors should ask when evaluating investment managers.

 

People, Process, and Performance

Many wealth advisory firms talk about “the three P’s” of manager due diligence: people, process, and performance. It is important to note that performance is only one of the three categories. While performance is always an important consideration, the overriding goal is to determine whether the manager is likely to deliver on its promises and whether the manager’s approach is a fit for the advisor’s clients.

Here are some of the most important questions that advisors should ask when evaluating the three P’s during the due diligence process:

 

People

• Who are the decision makers at the firm, and how long have they been there? Are key decisions for the firm made by an individual or by a management committee? Longevity indicates stability, but more recent additions to the team aren’t necessarily a negative.

• Are investment strategies/funds managed by a single portfolio manager (PM) or by teams? Either way, a wealth advisor should seek to understand whether the current PM or team generated the strategy’s published track record. If not, additional due diligence should be conducted to determine whether the current team uses the same approach that produced the track record.

• How many analysts does the firm have, and how are they compensated? It is important to understand the key drivers of compensation. For example, rewarding analysts when investment recommendations turn out to be “winners” but not when they suggest selling a position can create perverse incentives.

• Do the PMs and analysts invest their own money alongside clients? In other words, do they eat their own cooking? Having skin in the game can lead to better alignment of incentives between investment managers and their clients.

 

Process

• Is there a well-defined, disciplined investment process, or are investments largely based on a portfolio manager’s intuition? Firms that stick to a process should have examples of when returns were disappointing but they remained true to their established process.

• Is the strategy’s benchmark appropriate? For example, a small-cap growth strategy should not use the S&P 500 Index (a large-cap index) as its benchmark.

• What controls are in place to ensure that the fund stays true to its stated objectives? For example, a value fund that outperforms its benchmark by buying high-flying growth stocks likely lacks a rigorous and consistent process.

• How does the asset manager define the level of risk the strategy is allowed to take? What processes are in place to monitor and measure risk? Risk control is a key part of the investment process that shouldn’t be overlooked.

• In addition to managing investment risk, how does the firm limit operational risk? For example, duties should be appropriately separated to limit the risk of fraud and other potential operational issues.

 

Performance

• Are returns over time consistent with the strategy’s stated objectives? Is the fund true to its stated style? For example, if a small-cap growth fund outperformed the overall market when small-cap growth stocks generally underperformed, the fund may not be sticking to its style to an appropriate degree.

• Does an actively managed strategy (i.e., one that deliberately doesn’t seek to mirror an index) have a track record of beating its benchmark enough to justify its fees? If not, it may make more sense to use an ETF or a passively managed mutual fund to obtain the desired exposure.

• Is the manager a “closet indexer,” closely mimicking the benchmark by holding most of its constituents in similar proportions? Wealth advisors should not pay active asset management fees for a strategy that has little chance of beating the benchmark.

• How long does the manager tend to hold its positions? Long hold periods show conviction and can lead to tax efficiency. Short hold periods may indicate that the manager is pursuing short-term trading profits rather than long-term investing.

These questions apply to managers across all asset classes, but additional due diligence is required in many cases. For example, for private equity and other private asset classes, it is important to carefully review legal documents and manager compensation terms due to the relatively illiquid nature of many private investments.

 

What areas of manager due diligence does BDO Wealth Advisors emphasize?

At BDO Wealth Advisors, we believe the people aspect of due diligence is especially critical. We seek to invest with managers that offer us direct access to the individuals who are managing our clients’ money. We want to build relationships with these people, learn how they think and behave, and have the opportunity to engage with them directly when questions or issues arise. This often means avoiding the largest funds and looking to smaller managers for opportunities. Just as we expect and encourage prospective clients to ask questions about our firm before choosing us, we expect asset managers to welcome BDO’s questions about their people, processes, and performance on behalf of our clients.

 

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