Ten. The Scouting Report
What’s the game plan?
Finding the right players to create winning chemistry is critical to a successful season. Do you think Michael Jordan’s coach, Phil Jackson, could have won 13 NBA championships and reached the levels of success he did without extensive preparation?
Jackson spent hours analyzing an opposing team’s strengths and weaknesses—the areas in their playbook that represented potential problems and any weaknesses that could be exploited. Competing with and against the best players and coaches in the world meant that even the smallest detail could wind up being the difference between victory and defeat.
Since he was the ultimate “player’s coach,” he could relate well to the individual players as well as the overall team to get the most out of both. That meant he was often burdened with younger players without the experience and natural skill set of their large-market counterparts. Yet he was able to effectively manage the egos, immaturity, and inexperience of his players. The professional challenges Jackson faced were enormous, but he always seemed to come out on top, thanks to the mental toughness and knack for preparation he’d developed over the years.
In the financial world, investment teams at large and small firms are always looking to recruit talented individuals to strengthen their performance. Sound familiar? Each player (investment manager) is sought by these “coaches” (head of an investment team) for a specific set of skills they bring based on the needs of the team. While not all information is public, the Internet has opened up more access than ever before. Investors should try to investigate as much as possible prior to investing.
In 2010, a man named Geoffrey Lunn claimed to be Vice President of Dresdner Financial, a company that could turn an initial investment of $44,000 into $2 million in less than three weeks through its .44 Magnum Leveraged Financing Program. He was able to gain some semblance of legitimacy with his scheme by saying his company was connected to the very real Dresdner Bank in Germany. Of course, Dresdner Financial never existed and Lunn gave almost one million dollars of the money he collected to Las Vegas call girls.123
123 SEC News Digest, U.S. Securities and Exchange Commission, “SEC Charges Trio in ‘.44 Magnum’ Investment Scheme,” October 19, 2012.
In late 2012, the SEC charged the purported money manager with defrauding investors in the fake company he created. “Lunn [and his partners] created an aura of credibility by inventing a fictitious firm with a name similar to a legitimate company,” a statement from the SEC said. “But their 100% guaranteed investment program and the astronomical returns they promised were nothing more than an elaborate hoax.”124
124 Ibid.
In an illustration of how even the most sophisticated investors can fall victim to the craziest of con men, Lunn told SEC investigators that he had been forced to run the scheme by a one-eyed man who threatened to kill him and his family.125 How was Lunn able to get away with his alleged con for so long? After all, it would have required only a few phone calls to Dresdner Bank (now Commerzbank) for the fraud to be revealed.
125 Ibid.
Due Diligence: A Fundamental Layup
In the financial services industry, due diligence is a term used to describe the research and analysis an investor or financial professional will take before a financial transaction.
I take this to mean researching any company to the extent possible before handing over any of your money. If due diligence isn’t properly performed, the investor could experience devastating consequences. Unfortunately, even if proper due diligence is performed, investors can still find themselves involved in a scam and losing money, something that was painfully apparent when the fraud perpetrated by legendary money manager Bernie Madoff was finally exposed.
The necessary level of due diligence depends on the type of investment and the person investing. Take private placements as an example. Private placement investments are often limited to certain qualified investors (meaning they must meet certain criteria, such as a minimum level of investable assets) or institutions. The due diligence for these types of investments is often conducted by specialized firms acting under specific legal guidelines. Investments seen as more widely available, such as mutual funds, have enough information in the public sphere for investors to undertake the research themselves. One consideration for an investor is to understand how the manager performed under different market conditions. One popular resource that can help with this is Morningstar’s five-star system of fund evaluation. The company rates each mutual fund by assigning it a value anywhere from one to five stars. Time periods include the previous three, five, and ten years. Morningstar’s system is meant to be intuitive and easy to understand.
Size and Reach: Is Bigger Better?
Due diligence is one advantage often attributed to larger money managers and their firms. It doesn’t necessarily lessen the appeal of using smaller boutique firms in certain situations (those with narrow areas of expertise and experience). Yet larger firms can take advantage of their size to affect the amount of research they are able to conduct. In addition to due diligence, larger firms may offer economies of scale in other areas as well, but that is a discussion for another book.
Team Performance: Stars vs. Cellars
The stakes couldn’t be higher, and money managers are often hard-pressed to repeat top performance. In fact, a study conducted by S&P Dow Jones Indices found that very few mutual funds are among the top performers year after year. Specifically, at the end of March 2013, they found that less than 5% of mutual funds were among the top performers three years in a row.126 I think the discrepancy can be contributed to a multitude of causes, including investment objective, operations, people, and scalability.
126 Aye M. Soe and Frank Luo, S&P Dow Jones Indices, McGraw Hill Financial, “Does Past Performance Matter? The Persistence Scorecard,” July 2013.
Preparation: The REIT Way to Do It
As alternative investment strategies become more available to the average investor through retail products, how does one go about ensuring that proper due diligence is performed? While the necessary information exists, how is it accessed?
When looking at the performance history of a potential alternative manager, be prepared for a wide disparity in returns, due to the unique return structure of alternative investments. For example, a REIT (real estate investment trust) is a way for individuals to invest in income-producing real estate without having to actually buy a single, tangible piece of property. A retail investor can buy shares in a REIT that in turn invests in many different kinds of real estate. REITs could provide diversification in one’s portfolio if used strategically. Yet the real estate market is not monolithic; it’s regional and varies by type and investment objective. A wide swing in performance is experienced and attributed to the vagaries of the real estate market and the specific type of underlying investments contained within the REIT. Because of all this, real estate fund returns provide a historical example of return disparity. In 2011, the best REIT performers were up more than 25% and the worst REIT performers were down almost 30%.127
127 Lipper, a Thomson Reuters Company, 2013.
Individual investors, or the financial professionals they employ to determine if a particular investment is appropriate for a given situation, may consider a host of variables, including those we have covered, such as correlation, risk, and fees. Yet other variables, often less thought about, may be considered as well, including the on-time reporting of performance and taxes. Another consideration is the alternative investment manager’s performance and experience within the industry. Is the manager transparent about the process he’s developed and his own history and tenure in the business? Whether or not these answers are satisfactory, and how easy they are to find, are early indications of the manager’s style and philosophy.
Expensive Egos: Managing the Managers
What level of access and information are financial professionals able to receive from prospective money managers with whom they are looking to invest their client’s money? A number of issues arise when attempting to gain such access, one being time constraints. There simply are not enough hours in the day for a manager to meet personally with each financial professional or large investor, so time is usually reserved for those with assets over a certain amount. So how do new financial professionals, or even the retail investors themselves, perform due diligence prior to selection?
One option for the financial professional is to hire third-party providers who specialize in performing due diligence on all sorts of companies and investment managers. For a fee, the information is collected, made available, and easy to sort and digest with the right amount of time and personnel. Large companies exist that can provide wide swaths of information, as do smaller boutique firms with a narrow, more specialized focus on just one sector or industry. It would be difficult for an average retail investor to complete this type of due diligence process without a financial professional. Consulting a financial professional is one way. Not only can a financial professional try to break you of bad investing habits while instilling good investing habits, they’re familiar with the due diligence process. In fact, it is their responsibility to determine what investments are suitable for their client’s specific situation.
Individual investors may want to consider the following method to evaluate an alternative investment manager (and the manager’s strategy): scrutinize the manager through the lens of your goals, rather than against a standard investment benchmark performance. I always point to Warren Olsen’s six “Ps” when providing examples of these criteria: product, people, philosophy, process, period, and performance.128
128 Warren Olsen, Business Journal, “Wealth Management Should Start with the 6 Ps,” March 27, 2005.
From the Alt Vault: Valuable Takeaways from Chapter Ten
Investing without the proper preparation is not usually a good choice. Due diligence is a process to research and evaluate money managers. The level of due diligence may depend on the investment type.
A host of variables may be considered to determine the appropriateness of a particular investment.
Transparency and a repeatable process are early indications of an investment worth considering.
Professional help in the form of a financial advisor is strongly recommended.
What’s next: Money managers who employ alternative investment strategies, similar to those that were once reserved for high-net-worth investors, are finding ways to bring them to the average investor. What’s driving the change and how are these strategies accessed?