N O R T H E R N T R U S T Investment Due Diligence Art and Science May 16, 2012 Andrew C Smith, CFA, CAIA CIO, Client Solutions Group Northern Trust Global Investments 2012 Northern Trust Corporation northerntrust.com Slides provided by speaker 1
Agenda Investment Due Diligence - Art and Science Service Expertise Integrity Why Due Diligence? How Much Due Diligence? Quantitative versus Qualitative Due Diligence. Initial and Ongoing Due Diligence. Principles of Due Diligence. Portfolio Context. Art and Science. 2 CFA Wealth Conference Slides provided by speaker 2
Disclaimer This paper is provided for informational purposes only and is not intended as investment advice or an offer or solicitation for the purchase or sale of any security or financial instrument, and is subject to change without notice. Opinions expressed are those of the author and may not reflect the opinions of NT Global Advisors, Inc. or its affiliates 3 CFA Wealth Conference Slides provided by speaker 3
Why Due Diligence Cost Avoidance Due diligence should be performed prior to the decision to invest. Avoiding mistakes. Better to prevent fires than to put them out after the damage is done. Biggest Mistake: Doing due diligence after you are committed. Investor Psychology: Confirmation Bias Due diligence should be performed independently. 4 CFA Wealth Conference Slides provided by speaker 4
Why Due Diligence? Knowledge. Due diligence is not performed in a vacuum. It is performed relative to the client and the investment Where due diligence begins: The Client. Nature of the Relationship. Level of Sophistication. Level of Engagement. The Investment. Characteristics. Complexity. Transparency. Risks. Reward structure. 5 CFA Wealth Conference Slides provided by speaker 5
Why Due Diligence: - Alignment Due diligence should address issues of alignment with investor. Determining Alignment: Of Incentives. Of Objectives. Of Priorities Regardless of the quality of the strategy; misalignment of incentives, objectives, or priorities between manager and investor should be a showstopper. 6 CFA Wealth Conference Slides provided by speaker 6
Why Due Diligence? Safeguard Good due diligence is protection against unforeseen consequences. Safeguard: Demonstrates process. Documents knowledge. Defense against hindsight. Robust, Rigorous, Repeatable Process 7 CFA Wealth Conference Slides provided by speaker 7
How Much Due Diligence? Understand your responsibilities What level of due diligence are you accountable for? Appropriate to client sophistication. Appropriate to client level of engagement. Appropriate to investment type/complexity.. If in doubt; seek advice. 8 CFA Wealth Conference Slides provided by speaker 8
How Much Due Diligence? Types of Investment Due Diligence Investment Research: Focus on Investment people, philosophy, process, performance. Operational Due Diligence: Focus on operational risks, resources, policies, procedures, environment. Compliance: Focus on regulatory compliance, (policies, procedures, tools, infractions). 9 CFA Wealth Conference Slides provided by speaker 9
How Much Due Diligence? Investment Research: Focus on Investment people, philosophy, process, performance. Is philosophy, process, performance understandable? Does current portfolio and past results accurately reflect philosophy and process? Is there evidence of skill? Or comparative advantage? Are the skilled people a) present b) motivated c) supported? Is the process repeatable? Are the risks well understood, well defined, and well managed? Are there conflicts of interest? Is there a good control environment? What is reputation for integrity? 10 CFA Wealth Conference Slides provided by speaker 10
Quantitative versus Qualitative Due Diligence Quantitative Process (questionnaires, checklists, holdings and returns based analysis). Pro: Efficient method of data gathering Good documentation. Demonstrates attentiveness, process and knowledge. Con: Static view of risk. Rearward looking. 11 CFA Wealth Conference Necessary but insufficient Qualitative Process (on-site visit, interviews, reference checks) Pro: Forward looking Open ended. Active view of risk. Con: Expensive. Time consuming. Subjective. Looking For Red Flags. Critical factor Slides provided by speaker 11
Initial and Ongoing Due Diligence Due diligence does not stop after the initial investment. Risk is dynamic. Monitoring Quarterly Calls Annual On-sites Due diligence should be an ongoing process. 12 CFA Wealth Conference Slides provided by speaker 12
Principles of Due Diligence Key principles Ask the right questions Identify Risks. Look behind/look forward. Risks are not linear. Looking for signs: Red Flags Mosaic The future does not repeat the past, (but sometimes it rhymes). 13 CFA Wealth Conference Slides provided by speaker 13
Due Diligence and the Portfolio Context There Are No Perfect Investments Managed risks and unmanaged (residual) risks. Manage versus mitigate. Diversification and Position Sizing. In well managed portfolios due diligence and position sizing work hand in hand. 14 CFA Wealth Conference Slides provided by speaker 14
Due Diligence - Art and Science Adequate due diligence is a relative concept. Relative to client relationship. Relative to investment complexity. Relative to regulatory environment. Best practices. Quantitative and qualitative. Independent and ongoing (proactive). Backwards and forwards looking. Risk based. Documented Process oriented. Pay attention to: Mosaic- red flags. Alignment. Changes. Position sizing 15 CFA Wealth Conference Slides provided by speaker 15
N O R T H E R N T R U S T Questions and Answers 2012 Northern Trust Corporation northerntrust.com Slides provided by speaker 16
Appendix 2012 Northern Trust Corporation northerntrust.com Slides provided by speaker 17
N O R T H E R N T R U S T Northern Trust Global Advisors Due Diligence Process: Manager Research, Compliance and Operations May 2012 NTGA is currently known as Northern Trust Company of Connecticut 2012 Northern Trust Corporation northerntrust.com Slides provided by speaker 18
A Pioneer in Multi-Manager Solutions Research-based organization, with more than three decades of experience, driven to uncover and combine managers with the goal of providing superior returns in a risk-aware environment. Assets Under Advisement $21.1 BN $34.8 BN Assets Under Management Northern Trust s Multi-Manager Solutions business offerings include: Comprehensive Investment Outsourcing Emerging Manager Solutions Private Equity Solutions Hedge Fund Solutions Asset Class Solutions As of December 31 2011. Source: Northern Trust A pioneer in multi-manager solutions launching first program in 1979 Highly experienced and dedicated team of 108 investment professionals and research staff More than 250 managers currently used in client solutions Research team leveraging a global organization 19 CFA Wealth Conference Slides provided by speaker 19
Integrated Due Diligence Process NTGA s due diligence process extends beyond manager research to include an extensive review of a firm s operational and compliance practices and procedures. Qualitative and quantitative factors used to identify & select successful managers Ongoing monitoring process 1 Manager Research Assess operational risk and internal controls Ongoing monitoring process 3 Operations External Managers 2 Compliance Analysis of compliance program, risk controls Ongoing monitoring process Risk Control Overlay 20 CFA Wealth Conference Slides provided by speaker 20
Manager Research: External Manager Due Diligence Our research philosophy emphasizes qualitative understanding of a manager s investment beliefs, process, and professionals, coupled with solid quantitative analysis, in order to identify and select successful managers. People Proven experience in strategy Team structure Motivation and retention High integrity Philosophy and Process Clear investment philosophy Disciplined process Sound risk management Definable edge KEY CONSIDERATIONS Business Model Manager co-investment Appropriate ownership structure Infrastructure Satisfactory transparency Performance Quantitative analysis of various risk/return statistics Past success as well as mistakes Expectations of risk and return going forward Consistent and repeatable performance 21 CFA Wealth Conference Slides provided by speaker 21
Manager Research: Example How our qualitative analysis disqualified a small cap growth manager with extremely attractive long-term performance. Holdings-Based Analysis Uncovers Significant drift in investment style and strategy Significant micro cap exposure not in line with benchmark Analysis and Decision Process and performance not repeatable in future NTGA decided not to invest in this manager 22 CFA Wealth Conference Slides provided by speaker 22
Compliance Due Diligence Process for New Managers Compliance team analyzes and evaluates manager s compliance and internal control environment. Compliance Questionnaire Compliance governance Regulatory framework Compliance policies and procedures Trading policies and procedures Initial Review Review manager-provided documentation and responses to the questionnaire Conduct independent compliance research Compliance Due Diligence Corroborating Analysis Interview manager s key personnel Assess critical systems Manager s regulatory and reporting responsibilities Compliance Report Qualitative analysis of compliance program, risk controls Independent reports from compliance 23 CFA Wealth Conference Slides provided by speaker 23
Operational Due Diligence Process Operational risk is the potential that inadequate information systems, operating problems, product design and delivery difficulties, or catastrophes will result in unexpected losses. Operational Questionnaire Organizational structure and operating model Operations and trade order management processes Third-party service provider Business continuity and disaster recovery plans Initial Review Review manager-provided documentation and responses to the questionnaire Assign manager operational risk and internal controls Operational Due Diligence Corroborating Analysis Interview manager s key personnel Assess critical systems Confirm/revise manager s operational risk rating Operational Report Qualitative analysis of operations, internal controls Determine timing/scope of ongoing monitoring 24 CFA Wealth Conference Slides provided by speaker 24
Differentiating Factors What Makes Northern Trust s Manager of Managers Process Unique? Differentiating Factors A Focus on Small, Boutique Managers Unified Global Research Asset Management Approach to Manager Selection Portfolio Construction Greater motivation and less complacency, the right incentives in place One, cohesive global research department across all products Accountability for investment results Create powerful manager combinations Greater organizational flexibility to deal with changing market environment Provides good cross fertilization across the research team Deeper understanding of investment process and execution Minimizes style and market capitalization bets of individual managers Less bureaucratic working environment, allowing crisp decision making Greater appetite for risk among entrepreneurial owner-portfolio managers Ability to cast a wider net Client Centric Approach vs. Consultant or Broker Dealer Approach Captures managers stock picking abilities 25 CFA Wealth Conference Slides provided by speaker 25