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SACRS Fall Conference 2008


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Title: SACRS Fall Conference 2008

SACRS Fall Conference 2008
SACRS state association of county retirement syste
  • November 11-14, 2008
  • Costa Mesa, California

Large vs. Small What are the Implications and
Risks of Due Diligence Gone Soft?
SACRS state association of county retirement syste
  • Victor L. Hymes
  • CEO Chief Investment Officer
  • Legato Capital Management LLC

The Realities
  • We are in a high stakes COMPETITION
  • Our opponent is TIME
  • We race to uncover and exploit the next GREAT
  • Why this is so important

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
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?

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.
Two Directions, One Goal
  • Why Again?

We Love things we Think we can count, and Count
On therefore, value them as more reliable
Two Directions, One Goal
Two Directions, One Goal
  • The Key Phrase Is
  • 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

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?

Two Directions, One Goal
  • Who wouldnt be impressed by words and terms
  • 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

R-Squared Downside Risk Tracking Error Up Market
Capture Down Market Capture
What can happen when we reach an extreme?
The Risks of Imbalance
  • July and August of 2007
  • A period in time when Quantitative dominance
    virtually Silenced Qualitative known realities.

The Risks of Imbalance
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

The Risks of Imbalance
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.
  • These are the important reasons for committing
    adequate Quantitative and Qualitative resources
    to the practice of Due Diligence

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
  • The Numbers to the exclusion of all else!

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

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
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
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

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

Due Diligence by the Numbers
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
Due Diligence by the Numbers
  • Why statistics?
  • Saves time
  • Few question the numbers
  • All other forms of analysis are often messy

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!

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?

A Time for New Vision!
  • Quantitative and Qualitative data are equally
  • The relationship between Quantitative and
    Qualitative data is dynamic
  • Effective Qualitative due diligence feels much
    more like what we know as Vision

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!

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
  • 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
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

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
  • It should characterize the inputs required for
  • 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?

Questions and the Written Word
  • Every question should have a well thought out
    fundamental reason for its inclusion
  • Two Baskets

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

7Barclays was the exception. We have added value
this way and will continue to add value this way.
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

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

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

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
  • 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!

Large vs. Small What are the Implications and
Risks of Due Diligence Gone Soft?
SACRS state association of county retirement syste
  • Victor L. Hymes
  • CEO Chief Investment Officer
  • Legato Capital Management LLC
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