The History Of Manager Due Diligence

And Where We Went Wrong

1

Ron Surz, CIMA, MS, MBA

President, PPCA Inc

President, Target Date Solutions

(949)488-8339

Ron@PPCA-Inc.com

February 11, 2011 Webinar

Not Much Has Changed, But it Should

The Dark Ages

60s 70s 80s 90s 2000s

Schlepper/ Performance Reports

Manager Selection and

Due Diligence

Asset Allocation

Trusted Advisor

60s 70s 80s 90s 2000s

Indexes Peer

Groups

BlendedIndexes & Custom Peer Groups

The craft of delivering solutions

The craft of manager due diligence

It’s a Bad Joke

…each money manager has ready stories about other money

managers with low alphas who snatched clients through clever

marketing. Professor Meir Statman

I have never met a money manager who has performed below

median.

Every manager wins against the right benchmark.

We cannot change what we tolerate. The Madoff mess was

enabled by lax due diligence.3

Agenda

The Issues: Schools of Thought

Performance Evaluation: Benchmarking

and Significance Testing

Attribution: Getting Whys

Proof of Better Living Through Science

Using What We’ve Learned: Recognizing

Skill, & Portfolio Construction

4

Schools of Thought

5

Dave Loeper, President and CEO of Finance Ware

Insufficient value added given the time, energy and money to do

manager due diligence right. The potential benefits of manager

due diligence are outweighed by the costs.

Behavioral Finance Professor Meir Statman, What investors

Want

Investors demand active managers because they want to have

fun, and they’ll pay extra for it. It’s similar to diners choosing

fancy expensive restaurants.

Dr. Frank Sortino, The Sortino Framework for Constructing

Portfolios

Optimize around talent by integrating active with passive. Use

active where you find skill, and passive where you don’t.

Winners and Losers:

Use the right tools to address

the 2 central due diligence questions:

What does this manager do?

Indexes

Does he/she do it well?

Peer Groups

6

Truths

1. An index is NOT a benchmark, except for index

huggers and indexers. Tracking error is neither risk nor

value added.

2. Custom benchmarks best define what a manager does.

The intent is to capture the People, Process &

Philosophy. Building blocks (indexes) matter a lot.

7

Dr. William F. Sharpe

“It is desirable that the selected asset classes be:

Mutually Exclusive (no class should overlap with another)

Exhaustive (all securities should fit in the set of asset classes)

Neither S&P nor Russell indexes Meet These Criteria

“Determining a Fund’s Effective Asset Mix”, Investment Management Review,

December, 1988, pages 59-69.8

Creating Mutual Exclusivity

9

“Refining Core-Satellite Investing”,Journal of Performance Measurement, Fall 2010

Large Middle Small

Value

Core

Growth

Surz Style Pure® IndexesCore behaves differently than value and growth

1986 1997 2010

Surz Morningstar

10

Value-Growth Classification

Price/Earnings

Earnings are a Flow

Variable (Current)

Price/Book

Book Value is a Stock

Variable (Historical

Accounting)

Book values of some

large banks are

grossly overstated in

this financial crisis

11“Becoming Style Conscious”, Journal of Investing, Fall 2010

RJF RJF

NTRS NTRS

STT STT

MS MSAXPAXP UBSUBS

Citi Citi

BAC BACJPMJPM

WellsWells

Whose Style is it Anyway?Classifying Financials in Q2, 2010

Surz Style Pure® 3-Factor Model

Price/Earnings, Yield, Price/Book Price/Book

Value or Growth?Your Style Lens Makes a Big Difference for

Bank of America, Citigroup, UBS, and Morgan StanleyView your favorite stocks & indexes at:

< Style Scan >

= Centroid

Style Index Returns for the

3 Years Ending 2010

-6.5

-2.4

-1

-7.9

0.6

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2Russell 200 Surz Style Pure® Large Cap

Value Growth Value Growth

Core

A value manager that “Wins” against one index could easily “Lose”

against the other index. Ditto for growth. What does this manager

actually do?

Summary: Good Building Blocks for

Custom Benchmarks

Mutually Exclusive

Exhaustive

Dependable classification design

Regular rebalancing, more frequently than

annual

14

Winners and Losers

What does this manager do?

Custom Benchmark

Does he/she do it well?

15

Truths

1. Peer Groups all have a little known bias called

“Classification Bias.”

2. Statistical significance can be achieved over short

periods of time, but not with regressions (“alpha &

beta”). Use Hypothesis Testing instead.

16

17

CFA Institute

Benchmark Committee Report

•Be wary of peer groupsClassification, composition & survivor biases

•Use custom benchmarks instead

18

The Wait:Number of Years to Achieve SignificanceRegardless of the Benchmark, It Takes Decades to Exhibit Statistical Significance

0

20

40

60

80

100

120

140

160

A Little Skill Good Skill Great Skill

# of years = (1.35/IR)2 19

Test the Hypothesis “Performance is Good” using

Virtual Peer Groups (VPGs): Transforms a

Custom Benchmark into a “Peer Group”

Benchmark ConstructionRules

Simulator

PortfolioOpportunities

20

Style Universes for 2010

21

It’s all about the Future

Attribution: Strengths should

continue and failures are being

corrected

22

Truths

Knowing why (attribution) is the key, but if the

benchmark is wrong all of the analytics are wrong.

23

Custom Attribution

Sample Fund

Fund Return

24

Lg Growth

Lg

Value

Core

Evidence

Sortino Research Excess Omega using “best” style analysis

persists: published in Pensions &

Investments

Desired Target Return (DTR) Alpha can be

and actually has been achieved

The Trone Challenge Procedural Prudence vs Substantive

Prudence: Common vs “Best” Practices.

2005 performance contest

25

Truths

1) Custom benchmarks best define what a manager does.

Building blocks (indexes) matter a lot

2) Hypothesis testing reveals real success or failure.

Statistical significance can be achieved over short

periods of time by simulating the opportunity set.

3) Knowing why (attribution) is the key, but if the

benchmark is wrong all of the analytics are wrong.

26

Fine: How Can I Use This?

Demand the Best:

21st Century investment manager due

diligence. Always change a losing game.

(DOL and NASAA fiduciary requirement)

Portfolio optimization that blends skillful

active with passive where there is no skill.

27

INTEGRATE

28

Allocating (Indexes)

to Skillful Managers (Benchmarks)

Avoid the 4-corner solution

Large

Value

Large

Growth

Small

Value

Small

Growth

Coordination is the Key

CORE is the Locksmith

1. Find Skill by Looking Everywhere, not Just Style Corners. Use 21st Century tools.

2. Allocate to Skill to Maintain Diversification (Optimize).29

What will it take?

Advisors must demand that new & improved tools

are used by their due diligence providers.

If we don’t really care, the Loeper school makes the

most sense – don’t waste the money.

30

We’re all hardwired to resist change

31

•Attachment bias: Continued reliance on an approach for emotional reasons, such as “We’ve always done it this way.”

•Cognitive dissonance: The challenge of reconciling two opposing beliefs.

•Confirmation bias: The natural tendency to accept any information that confirms preconceived position and to disregard information that doesn’t support this position.

•Overconfidence: In combination with confirmation bias, the placement of too much emphasis on one’s own abilities.

•Status quo bias: The tendency to do nothing, even when action is in order.

•Laziness: Change takes effort.

The Folly of Common Practice

Common practice sometimes defies common sense.32

Bibliography

33

http://www.ppca-inc.com/WhitePapers/white_papers.htm

http://www.ppca-inc.com/Commentaries/Commentaries.htm

Questions Please

The Issues: Schools of Thought

Performance Evaluation: Benchmarking

and Significance Testing

Attribution: Getting Whys

Proof of Better Living Through Science

Integration: Portfolio Construction

34