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


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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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Why Again?

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We Love things we Think we can count, and Count On; therefore, value them as

more reliable

But…


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The Key Phrase Is:

THINK WE CAN COUNT AND COUNT ON!


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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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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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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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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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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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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Why statistics?

Saves time

Few question the numbers

All other forms of analysis are often messy

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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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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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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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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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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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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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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


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