What attributes should you look for in analyzing an investment advisory firm, financial planner, investment partnership, crowdfunding platform or other investment related offerings.
In this episode you’ll learn:
- What to look for in terms of people, process and performance in investing offerings.
- Why conviction, consistency, pragmatism, investment culture, risk management and active return are important attributes for successful investment firms.
- What are questions you should ask financial planners before hiring them.
Welcome to Money For the Rest of Us. This is a personal finance show on money – how it works, how to invest it and how to live without worrying about it. I’m your host, David Stein. Today is episode 175, and it’s titled “How to Conduct Investment Due Diligence.”
The topic suggestion came from Paul. He’s a member of Money For the Rest of Us Plus, and he writes:
“I would greatly appreciate you elaborating on what your approach is when interviewing a financial advisor. It’d be great to hear the things you are looking to find out, and a few example questions.”
Now, there are many times when — well, not many, but some point in your life you’re going to want to do some due diligence on a particular crowdfunding platform, perhaps a financial planner, a hedge fund… Maybe your neighbor or one of your best friends has started a hedge fund. I got an e-mail from another member of Money For the Rest of Us whose best friend started a foreign exchange firm, and he was interested in potentially investing with him and sent me the materials. We’ll talk a little bit about that today.
But there’s times that we’re presented with some type of financial advisor – maybe we have a booklet, or we meet with them in person, we talk to them, but we need some rules of thumb, heuristics to figure out “Is this an appropriate platform or person to trust my money with?”
I became an investment advisor when I turned 30, and up to that time I never had interviewed — I think I interviewed a stockbroker once, but I didn’t have any experience interviewing financial advisors or investment managers, but that’s what the firm that I joined did (a firm called Fund Evaluation Group).
We conducted due diligence on investment managers as part of our consulting services to not-for-profits, and we met with hundreds of managers per year… But you have to start with one, and I remember my first manager I interviewed was a firm named Anchor Capital Advisors. They’re still in business, they’re based in Boston; they were formed in 1983, and they’re a value manager. I met with (I guess) their head salesperson. He came to our offices in Cincinnati, he handed me their book, and my job was to conduct due diligence on them not knowing anything about what I should ask them. I had never met an investment manager. All I knew about our firm is we had the three P’s – performance, process and people.
So I asked them about their investment process, how did they go about investing, and he had some slides in his book that he could show me. I looked at the performance and I can see they had done fine from what I remember. Then we talked about the people, and that was sort of my frame of reference, my heuristic, my rules of thumb, just three P’s.
We also did due diligence on site. The first manager I ever met with was in New York, Oppenheimer Capital. They managed money for one of our clients, and I met with the PM. I don’t remember much about it, but you’re in their office–it’s helpful to visit the prospective advisor in their offices. You’re looking for red flags. Is there something that just strikes you as odd? I’ll give you an example in a few minutes of an analyst from our firm and I going to an investment firm, and something just struck as just odd.
But Oppenheimer capital – all I remember is I had taken a taxi probably 40 blocks down to Wall-Street area, and it was rush hour, and I was gonna take a taxi back, and she says “Here’s a subway token. Go down and take the subway. It’s so much faster.” And I didn’t know, I don’t think I had been in New York before. It was probably my first trip.
Learning from Bad Experiences
In episode #170, “Are Financial Markets Efficient?” I introduced a book by Andrew Lo called Adaptive Markets, and he talked about heuristics, rules of thumb, and how we develop those rules of thumb based on really bad experiences that leave a huge impact on our emotions.
In my early days as an investment advisor, some of the early experiences were defending managers that were underperforming. I had a client in Indiana that I took over from another consultant, and they had hired some small company growth managers at the very top. The manager’s performance was really, really good, because their style had really been in favor.
Later, one of those managers said that this particular university was their worst-performing client of all of their clients, because their style had been in favor, they performed over the one-year period, the three-year period, the five-year period, and since its inception.
One of the things to recognize with performance track records is very much that last year, if it shows significant outperformance, can significantly impact the longer-term returns. Conversely, when a manager has underperformed over the last year, that can impact the three-year return, the five-year return to some extent, and even the 10-year return if the underperformance is large enough.
But I didn’t know that as a new investment advisor. I wanted them to out-perform every single year, and you realize when we look at some additional rule of thumb or heuristics that this just isn’t possible. I learned that he hard way, sitting there in investment committee meeting after investment committee meeting, defending or explaining why the manager was doing so poorly.
After about a decade, I realize “Maybe there’s something more besides the three P’s.” I need more specific rules of thumb… So I remember meeting with an investment manager named John McStay in Dallas, Texas, and after the meeting just jotting down some attributes. What’s a more specific frame of reference for interviewing a manager? What am I looking for to determine whether a manager is skilled, or lucky?
I came up with these attributes that my former partners still use, and we’re going to go through them. I think these are rules of thumb when you’re looking at a new investment advisor, financial planner… Maybe they don’t all apply, but a little more specific.
The first is conviction. When you’re hiring an active manager, you want them to take active risk. You can buy an index fund or an exchange-traded fun very cheaply, so why pay a manager a percent or more if they’re going to just make little tweaks to the benchmark. Here’s how my former firm (FEG) puts it:
“Opportunities exist for managers with unique strategies and competencies to add value to a portfolio, beyond that of a passive representation of the market… Thus the search for alpha (which is another word for excess return) leads primarily to inefficient markets and unconstrained mandates. Resisting the temptation to constrain managers may provide opportunities for investors who rely upon a skillful manager’s knowledge and agility.”
So if you’re hiring an active manager, you’re looking for skill, you’re looking for their ability, and if they’re truly skilled, you don’t want to constrain them to a very narrow bucket, nor do you want a manager that has constrained themselves. For example, from Anchor Capital Advisors materials, they say “The companies we invest in can be in any industry or market sector, as long as the stock is selling at a price that is attractive to us and has what we believe to be a well-defined path to reach fair value.”
So they’re not constrained to an industry or sector. They’re unconstrained, and that’s why hedge funds often can be an appropriate investment vehicle if they’re actually skilled, because of the unconstrained mandate.
The second attribute, consistency. They don’t change their style when things aren’t going well. Maybe over a long period of time they make a tweak, but week-to-week, month-to-month, they stick to how they invest.
I gave an example if you go to episode #182 on what it takes to be a value manager of Harris Associates in the Oakmark Funds. We met with Robert Sanborn; he was a value manager that had significantly underperformed his peers and the benchmark. This was during the internet bubble, so late 1999… And they changed. They fired him. They changed how they invested because they were getting money coming (I believe) out of their mutual fund… So they weren’t consistent.
You want managers that are consistent, because it takes patience to be a good investment manager, so you want them consistently applying their skillset.
Another attribute – pragmatism. Markets, as we’ve talked about in episode #170, can be very efficient. It can be difficult to outperform the stock market, or even the bond market… And you need managers to understand that, that they’re able to clearly delineate what’s their edge, what’s their informational advantage, why is the security that they’re buying mispriced, and how do they know that and nobody else does?
Here’s how Anchor Capital Advisor puts it. They write:
“We find value by scrutinizing each company’s fundamentals. In a world of indices, ETFs and high-speed algorithm trading, we determine a company’s value by inspecting the infrastructure, examining the books and asking management the tough questions. From this data, we calculate an actual dollar figure for both the value of the company in the current market, and the potential value assuming a new product and management and strategies are successful.”
So if I was gonna interview anchor today, I would dig into that. “How do you do that? How do you get that informational edge?” They’re pragmatic, they realize there are other products, ETFs, so what are they doing differently? What are they learning as they talk to company management? And I would spend a lot of time with managers — in fact, I would call… If they say they’re doing successful due diligence on companies, I’d call the CFO of one of their holdings. Have you heard of the manager? How do they do at research?
This is an important component – talking to them, understanding, learning, asking them about mistakes… “Where have you made mistakes? Give me an example. What did you learn from it?”
Another attribute – investment culture. This is really the people, but how are you instilling into your people the way that you invest, and as you transition and bring up new analysts? I mentioned an analyst and I, we went to a firm – I won’t give their name, but they’re a mega-cap firm in Houston. They were on a recommended list; we hadn’t been there in a while… We visited their offices, and most of them were empty, nobody worked in them.
This was a firm that, as we talked to some of the portfolio managers — there were some red flags. Lack of people, lack of just anything really going on… And a little bit of defensiveness when we talked to them and asked them about their process. And there was some dispersion among the different client accounts. So we just weren’t comfortable with how the investment culture had evolved.
If I was gonna meet with Anchor today, they run nine investment strategies… Most of them value, but they have REITs, they have a balance, they have a focus… It’s a lot of strategies. Their portfolio – typically, they have 50-60 stocks, and their portfolio turnover is about 15%, which means they’re adding maybe 7-10 stocks/strategy. That potentially is a lot of new holdings, so I would ask them “How many analysts do you have and how many stocks are they covering? Do they have the capacity? How do you bring up new analysts?”
These are investment culture issues. Another attribute is risk management. They can’t be blind risk-takers. They need to understand what risk are they taking in their portfolio. What controls are in place? Where’s the money custodied at?
This Forex manager that one of the Plus members mentioned – they’re very specific in that Forex accounts are not segregated accounts. All their client accounts are lumped together, and then as they work with counter-parties, if a counter-party goes bankrupt or doesn’t deliver on the particular trade, that money is gone, so that’s a risk.
So these are the types of controls that we need to understand. When you’re looking at an investment advisor, do a Google search and put an “SEC” in the Google search to see “Has there been any type of administrative action against the manager?”
A final attribute is active return, the performance. What’s it been like? Is it too good to be true? Those that conducted due diligence on Bernie Madoff – the performance was just too consistent, too good to be true. And understand what’s driving the performance, what’s the attributes? This Forex manager is good in their disclosures, in that they say that the primary risk is volatility. Forex trading is traditionally volatile, with rapid fluctuations, and such prices are affected by a wide variety of factors that are complex, and difficult to predict, including political and economic events, supply and demand, and changes in investor sentiment. They’re hard to predict, and they’re extremely volatile.
As I looked through this performance track record — this Forex manager only managed about $175,000, so really, really small. And the performance is only a couple years old. It was two accounts, about $16,000 in each account. In the first two years they had used leverage, so the account was up 139%, but it was four times levered what their typical strategy was. It was volatile. It definitely was volatile. You could lose 40% in one month, and then gain back 16%. That’s why you want to look at a record.
If you look at, for example, 2008… If they were managing money then, how did they do? What was that like for them? How did they implement their strategy?
What are the fees? Fees are an important component of performance. Have they backed out the fees?
Anchor Capital Advisors, for example – they do managed accounts, and they show gross of fees and they show net of fees. Net of fees – pretty much every strategy has underperformed.
Then you’ve gotta look at the footnotes, and the disclosures say that they have assumed the highest fees of any platform that their managed account program is hosted on, which is 3%. So not every account that uses Anchor is going to be paying 3%, but the most expensive is, and that’s what they do net of fees. It’s helpful that the performance track record is audited. That’s the gold standard – is it audited by a third-party accounting firm? And how much money is managed with the account? In other words, is the track record based on $16,000?
Those are the attributes I look for when researching an investment advisor: conviction, consistency, pragmatism, investment culture, risk management and active return. Did they outperform their specific benchmark, at least since inception? It doesn’t have to be every period. Most managers are not gonna perform every single period, but if you have confidence in their process, their people, their culture, you can actually hire a manager that has underperformed in the short-term if you understand why their style is out of favor, and then benefit as the performance comes back into favor.
Putting it Into Practice
Now, recently I looked at a crowdfunding platform. I discussed it on Money For the Rest of Us Plus, and I’m not going to mention the one… They actually called me back, because apparently one of the members decided not to invest in the platform after I did a second show on them. I had to talk to the platform in person and they weren’t really happy about that when they called back. So, I won’t give the name, but they’re buying mortgages – deeply discounted mortgages, and then working with the homeowners to get them to stay in the home… And I was actually intrigued by it.
I called them up and asked some of these questions to understand their attributes, their process, and didn’t get a good feeling… When I asked them about the consistency of their process, or trying to understand their pragmatism, they just — for example, “How do you acquire new loans?”, the answer was “I don’t know. The CEO works on that”, and they didn’t know. And there wasn’t a performance track record to analyze.
They wouldn’t even tell me how much they had under management. Later, they called back and gave me that information. But you need a ton of information to make your due diligence decision. They should be very, very open about their process, the people… And again, you can use these attributes as a frame of reference.
So I didn’t invest with this particular strategy, and maybe it’s doing very well. They’re promising up to 12% return. I didn’t get a good feeling about it, because I couldn’t get the amount of information that I wanted. Now, these same attributes you could use, maybe tweak them a little bit, if you’re hiring a financial planner.
I had a recent member approach me… He had gotten 1,5 million dollars from a windfall, because the company he worked for went public. Now he’s a millionaire, and he wanted help to figure out “Does he have enough to retire? Is he on track to retire?” so he hired a financial planner. He sent me the copy of the report and asked what I thought about it.
I wasn’t giving advice; this was just part of the general education, the weekly Plus episodes for members, and it’s a Q&A show, so I just shared my thoughts to all the members of what I thought about it.
I was really, really disappointed, because one of the most important things you can ask a potential financial planner – and I’ll share some other things to ask them – is their return assumptions. They’re going to do an asset allocation model, they’re going to project out what you can earn investing to figure out if you have enough to retire, and they’re gonna recommend a portfolio allocation – so much in stocks, and bonds…
So the question is “What returns are they using?” That’s a valid question to ask. How do you come up with your returns? And they should be disclosed. Advisors will disclose them in the footnotes, so that’s the first thing I did, because I couldn’t figure out how the recommended portfolio was gonna generate 8% returns.
You look at the footnotes, and they had used historical returns. So they’re assuming 4.8% for the bond market. That’s just not gonna happen with yields at 2%-2,5%. Over the next decade, bonds are not gonna return 4,5%-5%. They’re assuming 9,5%-10,5% for U.S. stocks. The U.S. stock market valued at a price-to-earnings ratio of well over 20 is just not gonna get 9,5%-10%. So you look at the return assumptions, and in this case the analysis essentially was worthless, because of the returns that were used.
So when you’re interviewing a financial planner, you want to ask them about the asset allocation assumptions. You want to ask them about their planning philosophy.
I was speaking to a Plus member the other day that’s considering transitioning from an attorney to being a financial planner, and we talked about all the different types of financial planners there are, and the type depends on very much their business model. You should look at how many clients they have and the average fee their client is paying. If the average fee is low, they’re going to need hundreds of clients to make a business. But if their average fee is higher, they need less clients, in which case they’re going to be able to give you more attention.
When you’re looking at a financial planner, you want to understand what’s their business model, how are they compensated, how much are they compensated, what’s their philosophy, what promise are they making to you in terms of how you’re going to be changed after working with them. Is it a holistic approach, where “Yeah, we look at the numbers, but we’re primarily there for emotional support, keeping you on track.” So understand what it is you’re hiring. And you probably should get references and talk to some of their other clients. “How has it been working with him/her?” Talk to a number of people, because this is going to be a long-term relationship. Find out what their philosophy is, what is it that they’re promising to do, and what’s the relationship going to be like, and make sure that the amount you’re paying makes sense. If it’s going to be a very hands-on relationship, you’re going to pay more for that.
That’s episode #175. The bottom line is trying to see if there’s any red flags. Do you trust them? Look at all the documentation, look at the disclosures, read as much as you can, check SEC reports, meet with them in person, preferably in their office, ask for references, talk to their other clients – perhaps if they’re an investment advisor or an investment manager, buying individual stocks. You could ask them that you want to talk to some of the companies that they invest in. Now, it depends on how much you’re going to put with them, but make sure you know what you own, and who you own, and why you trust them, and make sure it’s just not too good to be true. Because if it’s too good to be true, maybe there’s something underneath that you’re just not seeing or picking up on.
Show notes are at moneyfortherestofus.com. While you’re there, sign up for my Insider’s Guide and I’ll send you a weekly e-mail with those links, and a weekly essay that’s not published anywhere else, where I share perhaps thoughts on that week’s episode, or something else that I experience that week that I wanted to share with you that just didn’t fit in the episode. I try to add as much value as possible in that weekly Insider’s Guide, and you can sign up for that at moneyfortherestofus.com.
Everything I’ve shared with you in this episode has been for general education. I’ve not considered your specific risk profile, I’ve not provided investment advice. It’s simply general education on money, investing and the economy. Have a great week!