Financial Opinion and Insights

Money Manager Due Diligence – It’s About Process

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Selecting the right money managers for your serious assets isn’t something to take lightly.  Unfortunately, too many people take far too many shortcuts, going straight to ‘star ratings’ and other `easy answer’ vehicles, and sidestepping altogether the data collection, situation needs-analysis, risk assessment, and Investment Policy Statement (IPS) steps so necessary to the manager screening process.  Let’s face it:  While every manager might be right for somebody, no manager is right for everybody.

But, once those steps are completed and you have your Investment Policy Statement, what are the steps required to conduct a true due-diligence process?

Here’s a brief thumbnail overview to get you started on the right foot – or maybe to help you assess whether your advisor has adopted a prudent investment process.

  1. Performance numbers:  While most of us are aware that past performance is of limited value in determining future performance, it does help narrow the list of potential candidates.    I’ve provided some insight into this in a previous post, Understanding Management’s Value.  You’ll want to consider time-weighted composites of actual results, quarterly returns, and both gross and net of fees.  One thing to look for, of course, is consistency over different time frames.  I personally like to see five years from an equity manager and three years from a bond manager.
  2. Performance relative to assumed risk:  There are several measures you can use here, such as the Sharpe ratio, alpha, beta, and standard deviation.  If you’re not familiar with these, you can learn about them or ask your financial advisor for help
  3. Performance among peers: Here it’s important to have third-party objective evaluations.  Briefly, you don’t want to compare a domestic large-cap value manager with an international mid-cap growth manager.  You’d be surprised how often people compare apples and oranges, utterly convinced their comparisons are valid.
  4. Manager’s Adherence to Stated Investment Style:  Let’s face it, if you’ve selected a manager because of their investment process and proven ability as a value investor, you don’t want that manager to begin making earnings-based investment decisions.  This ‘style drift’ into growth investing destroys your allocation strategy.  Part of the due diligence process is constantly confirming that the manager consistently follows a process and doesn’t chase fads or ‘hot’ sectors.  ‘Chasing returns’ is for amateurs, not professionals.
  5. Performance in both `up’ and ‘down’ markets:  Bull markets can make bad managers look good.  Everyone’s a sailor when the seas are calm and the wind is at your back.  It’s when the wind is against you and the seas are choppy – when you have to put down your champagne glass and work with the sails – that we find out who the true sailors are.  Most pros would gladly accept a manager that experiences only 80% of the upside if the downside experience is only 70%.  It’s important to note, too, that even in a bull market you might expect better than a 1 in 4 chance that a portfolio will go down before it begins to go up.  Individual investors typically want all the upside with none of the downside; so, for many, the concept of relative performance over time is an education process.
  6. Performance of key decision makers and their organizations:  Even those firms that use a ‘black box’ – quantitative models – to arrive at their decisions, still need people to interpret and implement the output.  Some of the areas of interest are ownership (vested interest), size of the firm (focus), assets under management (concentration), change in personnel, trading capability (costs), research (in-house vs. purchased, soft-dollars (using transaction costs to cover manager expenses), conflicts of interest (broker-dealer affiliates, banks, insurance companies, or investment companies (mutual funds) need to affirm that their money management operations are completely independent of other corporate activities – ethical walls may exist in theory but can be hard to carry out in practice).

This is overly brief, to be sure; but it might provide a little insight on how extensive a prudent manager selection process is and why there are seldom any quick or easy answers. 

It’s also important to reiterate that the process should always be conducted in light of the Investment Policy Statement (IPS) that was created upon the completion of a well-constructed investment plan… and that is, as you might expect, only as good as its input on the data collection, risk assessment, and goal-setting components.


Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, http://www.indfin.com.