11 sacrs fall conference 2008 november 11-14, 2008 costa mesa, california sacrs state association of...
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SACRS Fall Conference 2008
November 11-14, 2008Costa Mesa, California
SACRSstateassociation ofcountyretirementsystems
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Large vs. Small: What are the Implications and Risks of Due Diligence Gone Soft?
Victor L. HymesCEO & Chief Investment OfficerLegato Capital Management LLC
SACRSstateassociation ofcountyretirementsystems
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The Realities
We are in a high stakes COMPETITION
Our opponent is TIME
We race to uncover and exploit the next GREAT OPPORTUNITY
Why this is so important: $
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The Issues
How do we identify the top performing managers?
How shall we define a top performing manager?
Highest Risk-Adjusted Returns and Consistent Alpha
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1. Quantitative 2. Qualitative
Observations
Tools to measure each Direction differ greatly
Quantitative Data: Easy to find and Organize
Qualitative Data: Messy and Hard to Value
Question: Are we placing too much relative
weight on Quantitative vs. Qualitative Data?
Yes!
Two Directions, One Goal
Why?
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TECHNOLOGY!
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Due Diligence by the Numbers
Technology has allowed each of us to connect with millions of pieces of data almost instantaneously, and access that data from any place on the planet.
We’ve answered the call for more data by installing larger databases, networks and faster processors, hiring more and more PhD’s-to help us analyze, organize and even identify the need for more data.
Ironically, one of the many reasons
for collecting so much data is to
somehow better understand human
behavior, and how that behavior
affects the purchase of goods and
services, advertising, you name it.
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Two Directions, One Goal
Why Again?
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We Love things we Think we can count, and Count On; therefore, value them as
more reliable
But…
Two Directions, One Goal
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The Key Phrase Is:
THINK WE CAN COUNT AND COUNT ON!
Two Directions, One Goal
Our Fear: Without Quantitative Data, we’d be relegated to the world of -- Touchy Feely, Emotion, Impulse and Love
Love? Important to all in some shape or form, but impossible to define or predict
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Two Directions, One Goal
Are these “touchy feely” aspects restricted to the Qualitative side of Analysis?
NO!
But, they do take a different form!
A Love built on Quantitative Data, is a love of the manipulative nature of numbers that can be made to look like hard facts, based on long-proven theories, and…look really nice in Client Books!
Further, without the Words and Phrases which have become the universal language of this numbers game, where would the world be?
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Two Directions, One Goal Who wouldn’t be impressed by words and terms like?
Standard Deviation
Sharpe Ratio
Information Ratio
Alpha
Beta
Treynor Ratio
Is there ever a risk of imbalance between the weight given to Quantitative vs. Qualitative insights?
R-Squared
Downside Risk
Tracking Error
Up Market Capture
Down Market Capture
Yes!
What can happen when we reach an extreme?
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The Risks of Imbalance
July and August of 2007
A period in time when Quantitative dominance virtually Silenced Qualitative known realities.
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The Risks of Imbalance
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The Risks of Imbalance
It is difficult to identify the catalyst for dislocation prior to its introduction into the marketplace so, Quantitative and Qualitative analysis must remain in balance
It wasn’t just that things went wrong, but they went wrong at places that we thought had most, if not all, the answers; and track records to prove it!
What lessons did we learn, again?
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The Risks of Imbalance
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Multi-Dimensional Risks
1. We must remain cognizant of our tendency to place too much weight on the Quantitative vs. Qualitative aspects of Due Diligence
2. Due diligence is multi-dimensional spanning Large firm and Small firm, as well as, Quantitative vs. Qualitative
3. These are the important reasons for committing adequate Quantitative and Qualitative resources to the practice of Due Diligence
What lessons did we learn, again?
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Multi-Dimensional Risks
If we utilize different tools in performing Due Diligence on a Large Firm, than those utilized to analyze a Small Firm, we must embrace the fact that investigative techniques and questions may differ dramatically, depending on the size and complexity of the institution being examined.
The ultimate question is, which tools do we require that, when consistently applied, separate the wheat from the chaff?
To refuse to acknowledge and act upon the need for development of these tools, is to relegate your practice to the most competitive battleground:
The Numbers to the exclusion of all else!
The tools must match the job!
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Why Due Diligence and not Simply Random Selection?
We believe that “properly weighted and conducted” due diligence can reduce the risk of an improper or unsuccessful investment
A More Powerful reason:
We seek an organized process whereby certain tools, which increase insight, can be applied consistently to answer a common question concerning every stock, bond, derivative, strategy, process, portfolio etc.
How to achieve the greatest Risk vs. Reward solution.
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Due Diligence
To bring more structure to the process of illustrating the risk vs. reward component, we must first understand the characteristics of a due diligence process.
Two components
Qualitative The Intangibles
Quantitative The Numbers
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Due Diligence
Problem In the Quantitative case (the fun part); we’ve
forgotten the reason why it is so much fun. The tools are largely found in a seemingly infinitesimal number of Statistics.
Why should this concern you just a little bit?
For a number of reasons
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Due Diligence
Definition: Statistics The science that deals with the collection, classification, analysis, and
interpretation of numerical facts or data, and that, by use of mathematical theories of probability, imposes order and regularity on aggregates of more or less disparate elements1
Estimate2
Fact3
Sadly, this is the beginning and end for many practitioners of the Due Diligence process, but represents only the beginning for knowledgeable practitioners, prodding them to ask deeper questions.
1The Random House Dictionary of the English Language, The Unabridged Edition 19772Websters3Roget’s Thesaurus
Why is this a problem?
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Due Diligence by the Numbers
Statistical information is gathered and organized, then often utilized based on misunderstanding of the proper ways to use the underlying data, or even a cursory discussion of the weight one piece of data should carry vis-à-vis others
Judgments to select manager or fund A over manager or fund B often are based on numerical differences that might be largely irrelevant when key indicators, either quantitative or qualitative, are in essence ignored
Tragically for clients, many now believe numbers = truth = comfort
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Due Diligence by the Numbers
Glorio
us!
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Due Diligence in the KitchenQuantitativ
e 1 pound of lean
beef1/2 cup of flour1 liter of water
2 ounces of Thyme
Bake at 250 degrees 30 minutes
Qualitative A piece of fresh Halibut A pinch of ground nutmegA sprinkle of barbecue spiceA handful of Italian seasoningPlace on a coal-fired grill until soft
to the touch
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Due Diligence by the Numbers
Why statistics?
Saves time
Few question the numbers
All other forms of analysis are often messy
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Due Diligence by the Numbers
With all the brain power in this room today, wouldn’t you be willing to make a bet that you could improve your decision-making success by increasing your commitment to the Qualitative side, with regard to due diligence?
What if you could gain a greater share of the market? Would that be enough?
Apparently not!
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Due DiligenceBut why don’t we pay more attention to the Qualitative
Side?
Beyond operational infrastructure and compliance, it is difficult to quantify and, therefore, useless, right?
WRONG!
Further, the qualitative side deals with things like culture, passion, emotion, love, feelings, interpersonal dynamics, geography, intuition...and God knows we’re in the asset management business not the social science business Right?
WRONG AGAIN!
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A Time for New Vision!
Quantitative and Qualitative data are equally important
The relationship between Quantitative and Qualitative data is dynamic
Effective Qualitative due diligence feels much more like what we know as Vision
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A Time for New Vision!
Vision, like Alpha, is elusive
The art of effective Quantitative Due Diligence begins with introspection
You cannot begin to understand the qualitative aspects of an organization, strategy, team or its practitioners until you understand and neutralize your own personal biases
By definition, you will feel uncomfortable, and this is good!
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Road to Recovery and Solutions
Philosophy5:
The critical study of the basic principles and concepts of a particular branch of knowledge, with a view toward improving or reconstituting them
Process6:
A continuous action, operation, or series of changes taking place in a definite manner
The beginning-and-end of sound Due Diligence rests on one’s ability to understand the Philosophy and Process of the Practitioner
5The Random House Dictionary of the English Language, The Unabridged Edition 19776The Random House Dictionary of the English Language, The Unabridged Edition 1977
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Road to Recovery and Solutions
It should make intuitive sense
It should be sufficiently broad in scope
It should be relatively short and concise, easy to state
It should compel the listener to want to learn more
What are the components of a great Philosophy?
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Road to Recovery and Solutions
At its greatest level of detail, it gives relevance and support to the Philosophical beliefs
It should characterize the inputs required for construction
It should have little room for random chance
It should be larger than its practitioners
It should have a quality which enables it to evolve over time
Can it survive the flu?
Can you?
What are the components of a great Process?
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Questions and the Written Word
Every question should have a well thought out fundamental reason for its inclusion
Two Baskets
Qualitative Quantitative
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Road to Recovery and Solutions
A full and complete understanding of when the strategy does not work and have a plan for negotiating those often murky waters
A Full knowledge of how the manager has determined where their strategy adds value
For Great Quant shops, how you’ll know if they’re not sticking to their process?
A thorough reading of many Quant shop monthly and quarterly letters often leads one to believe there is no process—THIS MIGHT BE TRUE!
An understanding of whether the rationale for staying fully invested or pulling out is attributed to a committee meeting7
A sense that the team has a working knowledge of the strengths and weaknesses of each member, and that there is a mechanism for compensating actively for these dynamics
A sense that each team member represents the highest level of integrity, above average intelligence, good judgment and brings diverse, but complementary perspectives to the table
Knowledge regarding the mechanism for process evolution and evaluation
Specific knowledge of how they performed during several major market shocks (e.g., July and August 2007)-A good question is how did they do, but a great question is, did the portfolio perform as expected, from your point of view and theirs?
Before you leave that Due Diligence meeting, what should you have and know?
7Barclays was the exception. “We have added value this way and will continue to add value this way.”
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Road to Recovery and Solutions
Resume Deconstruction
The RFP Trap
– Manager cannot express his process on paper, but executes a credible process that requires work
– Manager expresses a process on paper that is not being used to drive the portfolio decisions
– Manager describes the firm’s process in aspirational terms-This is what we’d like our process to be
The benefits and disadvantages of relying on written materials – Many of the answers are right in front of you!
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Road to Recovery and Solutions
Don’t take away latitude, but understand the extreme boundaries
Understand the manager’s relationship with their custodian, auditor, prime broker and other vendors
The Alternatives classification nightmare
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Road to Recovery and Solutions
Great investment teams can exist within large institutions, but a healthy discussion with the CIO should provide a window into how long they can last, particularly if successful—Remember, healthy discomfort is a catalyst for transformational thinking and evolution
Ask the lead portfolio manager privately or with the portfolio management team present, if willing, to identify his/her 5 key research analysts
People to see and things to ask when performing on-site meetings inside a large organization
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Reliance on Quantitative data alone is our ticket to join the herd
The behavior of the herd extends farther than you think
DEATH to the knee-jerk requirement of 3 or 5 year track records – A Modern Day Example of how Poor our Qualitative Skills Have Become!
Road to Recovery and SolutionsWhy the Herd mentality can kill the most disciplined investor/consultant/client?
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Large vs. Small: What are the Implications and Risks of Due Diligence Gone Soft?
Victor L. HymesCEO & Chief Investment OfficerLegato Capital Management LLC
SACRSstateassociation ofcountyretirementsystems