SACRS Fall Conference 2008

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SACRS Fall Conference 2008
SACRS state association of county retirement syste
ms

• November 11-14, 2008
• Costa Mesa, California

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Large vs. Small What are the Implications and
Risks of Due Diligence Gone Soft?
SACRS state association of county retirement syste
ms

• Victor L. Hymes
• CEO Chief Investment Officer
• Legato 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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Two Directions, One Goal

• 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!
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.
• Weve answered the call for more data by
  installing larger databases, networks and faster
  processors, hiring more and more PhDs-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
Two Directions, One Goal
But
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Two Directions, One Goal

• The Key Phrase Is
• THINK WE CAN COUNT AND COUNT ON!

• Our Fear Without Quantitative Data, wed 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, andlook 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 wouldnt 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
What can happen when we reach an extreme?
Yes!
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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
What lessons did we learn, again?

• 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 wasnt 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!

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The Risks of Imbalance
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Multi-Dimensional Risks
What lessons did we learn, again?

• We must remain cognizant of our tendency to place
  too much weight on the Quantitative vs.
  Qualitative aspects of Due Diligence
• Due diligence is multi-dimensional spanning Large
  firm and Small firm, as well as, Quantitative vs.
  Qualitative
• These are the important reasons for committing
  adequate Quantitative and Qualitative resources
  to the practice of Due Diligence

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Multi-Dimensional Risks
The tools must match the job!

• 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!

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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) weve
  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.

Why is this a problem?
1The Random House Dictionary of the English
Language, The Unabridged Edition
1977 2Websters 3Rogets Thesaurus
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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
Glorious!
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Due Diligence in the Kitchen

• Quantitative
•  
• 1 pound of lean beef
• 1/2 cup of flour
• 1 liter of water
• 2 ounces of Thyme
• Bake at 250 degrees 30 minutes

Qualitative   A piece of fresh Halibut A pinch
of ground nutmeg A sprinkle of barbecue spice A
handful of Italian seasoning Place 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,
  wouldnt 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 Diligence

• But why dont 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 were 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
The beginning-and-end of sound Due Diligence
rests on ones ability to understand the
Philosophy and Process of the Practitioner

• 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

5The Random House Dictionary of the English
Language, The Unabridged Edition 1977 6The Random
House Dictionary of the English Language, The
Unabridged Edition 1977
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Road to Recovery and Solutions
What are the components of a great Philosophy?

• 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

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Road to Recovery and Solutions
What are the components of a great Process?

• 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?

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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
Before you leave that Due Diligence meeting, what
should you have and know?

• 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 youll know if theyre
  not sticking to their process?
• A thorough reading of many Quant shop monthly and
  quarterly letters often leads one to believe
  there is no processTHIS 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?

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
The benefits and disadvantages of relying on
written materials Many of the answers are right
in front of you!

• 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 firms process in
  aspirational terms-This is what wed like our
  process to be

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Road to Recovery and Solutions
The Alternatives classification nightmare

• Dont take away latitude, but understand the
  extreme boundaries
• Understand the managers relationship with their
  custodian, auditor, prime broker and other
  vendors

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Road to Recovery and Solutions
People to see and things to ask when performing
on-site meetings inside a large organization

• 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 successfulRemember,
  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

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Road to Recovery and Solutions
Why the Herd mentality can kill the most
disciplined investor/consultant/client?

• 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!

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Large vs. Small What are the Implications and
Risks of Due Diligence Gone Soft?
SACRS state association of county retirement syste
ms

• Victor L. Hymes
• CEO Chief Investment Officer
• Legato Capital Management LLC