Fund diligence in the post-Madoff era

One of the consequences that will result from the number of financial scandals that have plagued the market will likely be a greater fiduciary responsibility for advisors to do their homework on the funds they recommend, a panel on due diligence in Toronto emphasized.

The Alternative Investment Management Association (AIMA) of Canada brought together three due diligence experts to discuss what advisors should be doing to create better risk management in the funds they select for clients.

In the wake of hedge fund blowups like the fund run by Bernie Madoff, it’s become clear that investors really did not have an understanding of either what they were investing in or how to recognize they were deploying assets into fraudulent strategies. The panelists pointed out that a stringent due diligence process should be undertaken with all the investment funds an advisor recommends.

According to Judy Long, director of business conduct compliance with the Investment Industry Regulatory Organization of Canada (IIROC), advisors could be held accountable for putting a client into a fund that is unsuitable.

Motivated by the damage caused by unsuitable broker and advisor recommendations for asset backed commercial paper, IIROC released a number of product due diligence guidelines back in March.

The recommendations were broad, and Long’s advice to advisors was to the same effect. Essentially, she outlined that member firms should have a product due diligence framework in place, and advisors should follow it. Where the advisor liability comes into play is determining that a recommended investment is suitable for a specific client’s financial needs.

“It would be the advisor’s responsibility to take that information on [their firm’s] product due diligence process and expand it. Ask questions, because it’s your client, your livelihood, and it’s your suitability obligation,” she says. “Don’t be afraid to ask questions. Make sure you understand what the product is. Make sure it’s suitable for the client. If it doesn’t pass your smell test, start at step one and try again.”

The right smell test

What does a good “smell test” look like Don Lefresne, head of alternative investments with RBC Global Private Banking and Mark Purdy, managing director and chief investment officer with fund of hedge fund provider Arrow Hedge Partners, offered some of their tips for fund selection.

Lefresne says there are three risks advisors have to look at with a fund: business risk, operational risk and pedigree risk.

“Is this fund a viable business? A manager may be good at managing money, but that does not mean he may be good at running a business necessarily. There are factors in business, such as technology, marketing and even risk management that determine whether a fund is a good investment,” he says. “You need to determine what pedigree does a manager have? What experience and skill do they have? Can the manager demonstrate that skill with any consistency?”

Purdy looks at two things off the bat. First, he needs to be able to understand the strategy, if he doesn’t understand it, he doesn’t buy it. If he finds a strategy he understands and thinks has potential, he then does a reference check and analysis on the actual people running the fund.

“The people are extremely important. The reference check on those people is a big part of the process. You ask the right questions, people will generally not lie, even if they are friends with the managers,” he says. “The other reference check is with other investors. If they are pretty open about their experiences, that’s another good source of information.”

When it comes to other investors, try to determine if there are an abnormal amount of assets concentrated with a few investors. Even a well-run fund can run into serious problems if a major investor chooses to redeem their units.

Purdy also believes investors need to get in contact with the third-party operational partners of the fund, such as auditors, to make sure the fund is doing what it’s purporting and there are no serious operational risks.

Performance is only one measure

Both Purdy and Lefresne said past performance plays a small role in their selection of a fund. It’s important to ensure managers are competent in their style and have a consistent investment methodology that conforms to their prospectuses. They select funds based on their own future investment outlook, not the returns a fund has been able to generate in the past.

“Past performance rarely factors into my decision,” Lefresne says. “I look at what the environment is and where I expect things to go looking forward.”

Purdy emphasized tracking the consistency of a fund’s style. Fund strategies are not static strategies and the behaviour of managers can change over time. Due diligence requires making notes of those changes.

“For example, if the original strategy was designed for $200 million and now they are running $1 billion, does that make sense?” Purdy says. “Something we can point to as a big problem over the last 18 months is that managers took on too much capital and they didn’t have the infrastructure to deal with that capital, or their process changed from when they generated the returns that you’re basing your current decision on.”

Lefresne says getting to know the money managers is important, because changes in their lifestyle can affect the way they manage money. He concedes this is difficult for advisors. The wholesaler tends to be their point person for a given fund. He recommends an effort should be made to make contact with the people who are managing their client money.

“You’re going to want access to management. Take advantage of road shows because that where you as an advisor are going to get a chance to ask questions of the manager directly, especially if you haven’t been able to get the certain kinds of answers you wanted from your wholesaler,” he says.

In his personal experience, Lefresne says deterioration in the manager’s lifestyle has created problems in performance.

“Death, divorce, drugs — you name it, you’ve got to be able to track that because if you’re manager is not on their game you’ve got a problem,” he says. “I’m always going to have concerns if I’m calling a manager during business hours and he’s answering their phone on the back nine.”

(05/11/09)