Todd has five key questions he uses to successfully evaluate the managers he uses:
1. Does the manager (or team) have exceptional insight, work experience and/or academic success?
2. Does the manager employ a unique strategy that can capitalize on market inefficiencies (perhaps as a result of their intellectual edge)?
3. Does the manager have more firepower in terms of total experience, number of professionals, or systems?
4. Does the manager have better access to information than does his or her peers?
5. Does the manager have superior trading skills or systems that can enhance performance?
By and large, these questions can identify key facts that explain past performance (positive or negative) and, more importantly, can help provide a sense of whether a manager will be able to add value going forward. "If an advisor is doing the due diligence, then a complete organizational analysis must be completed as well," says Todd. Firms with superior back-office capabilities, low personnel turnover, independent firms with few conflicts of interest and firms with plenty of "skin in the game," as well as those with a specific specialty, attract Todd's attention.
Portfolio construction is a vital element to consider, as well, in the advisor's own due diligence effort. Todd emphasizes that it is imperative to understand the role of each manager in a portfolio before a manager search even begins. It is certainly possible for an investor to have an array of very talented managers, he says, but if the fit is awkward, total portfolio performance can be mediocre; for instance, deep value managers complemented by aggressive growth. "We saw many large stock portfolios in the late '90s comprised of an aggressive growth manager and a relative value manager. As the market tumbled in 2000-2002, the value manager was not nearly as defensive as the investor had hoped, and the portfolio was punished."
The process Todd explains may sound daunting, and many advisors will opt for outside expertise as a result. New platforms are being created that provide greater depth to due diligence and research services, and allow advisors to eliminate some of the tremendously time consuming work that needs to be done. Other third-party sources are teaming up with strategic partners to offer advisors more complete due diligence services, and explain the process they go through so the advisor knows the quality of the process and is able to better determine the appropriate fit with their clients (see accompanying sidebar).
How Deep Should Due Diligence Go?
The depth of due diligence performed is an important factor in advisors' responsibilities within the consulting process. "I would certainly advise other advisors to have their own due diligence process in a documented fashion," says Potter, "because you never know when it's going to end up in front of an arbitrator as to how you made this particular selection. In fact, if you look at it from a fiduciary standpoint for a foundation or a qualified plan, that's really the basis of arbitrator or court challenges-the question is, not what you came up with, it's how did you come up with it?"