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What to look for in a third-party investment manager

by | May 9, 2018 | UpClose

What to look for in a third-party investment manager

by | May 9, 2018 | UpClose |

Due diligence—through in-depth probing of an investment manager’s capabilities, track record, systems, and philosophy—is a prerequisite before committing your clients’ hard-earned assets.

As financial advisors, we constantly receive phone calls, emails, requests for meetings, invitations to webinars, and various other marketing approaches from third-party investment managers.

While these contacts are not unwelcome, our time is obviously a valuable resource, and we need to use it wisely. Many of these communications are from familiar names, such as the traditional mutual fund managers we have probably all worked with for years. We understand their products and services and know their history, management style, and, often, their representatives.

But we are also approached frequently by smaller, less-well-known investment-management firms that can range from true “boutiques” to midsized firms with sizable staffs and significant capabilities.

Besides simply looking at 1-, 3-, and 5-year performance numbers, what questions do we need to ask third-party money managers as part of our due diligence?

What is the quality and duration of their track record?

Generally, three to five years is the “sweet spot” most managers must achieve in order to become “believable.” During those three to five years, what was the market cycle like? Did their strategies perform as intended in good and bad markets? To make sure full market cycles are represented, it’s best to also examine how their strategies have performed over time frames longer than five years, if possible.

Specialized strategies should have expected periods of strategy underperformance. If a period of expected underperformance existed but the strategy was resilient, why was that? Do they attribute it to the manager’s ability, a special circumstance, or did they make alterations to their strategy during this period? It’s important to get a full understanding of performance expectations. Bad years are to be expected by all managers; they should be open and honest as to what market conditions should bring out underperformance. A manager without an understanding of this tends to get emotional when their strategy starts to underperform, which generally leads to more adverse results.

Is their process systematic, or does it rely on key individuals to make decisions and place trades?

Investment decisions can be manager-derived, automated, or systematic. The more systematic a process is, the more comfortable you can be with your future expectations. Systemization, to me, means there is an automated decision-making process in which a trading system will automatically make transactions based on a specific set of rules without human intervention.

If an investment process is automated but still requires trading by a human, you will need to ask some follow-up questions: What situations would cause them to override the process? Have they overridden their process in the past? Why was that? Do they have written procedures for such events, or is it discretionary?

If a manager has overridden their process in the past, what was the outcome? A manager that overrides their process based on a discretionary decision by the manager and has a good outcome may be more likely to intervene in the future. This “manager ego” can, and will, become problematic for long-term expectation of strategy performance. We have to ask, if a firm spends significant time doing research, developing a model, and extensively testing it—and then frequently overrides the model—why did they create the model in the first place? And does it still offer a valid and differentiated strategy?

Do they rely on a third party for critical data, research, or their trading systems? Do they have contingency plans? Is their performance reporting reliable?

We have met many managers that heavily rely on a subscription service and even signaling services from a third party. What happens to the strategy if there is a breakdown in the relationship between the two firms? These third-party services can be sold, merged, or even go out of business.

What type of performance-reporting systems do they use to deliver results, and what is the frequency? Technology has made performance reporting much easier in recent years. Front-end, client-facing, real-time reporting is now easy to integrate, but it comes at a high cost to the outside manager. Therefore, many smaller managers are still delivering monthly, one-page performance reports. You need to ask how reports are being generated and whether they are verified or audited by a third party before distribution. If not, is there a regular, systematic auditing/verification process in place?

You need to understand how crucial an outside relationship is to the performance of the strategy and see if there are any comparable alternatives in the marketplace. The more important a service is to a manager, the bigger the red flag—especially if there are no comparable alternatives in the marketplace.

Is their track record GIPS-compliant and verified? Can they provide you with audited figures?

Ask questions about the track record you have been given. What portion of the performance data was backtested? What was the confidence level of the backtest? Can they provide you with a Monte Carlo backtest? If the Monte Carlo backtest and real backtest do not show similar risk-return statistics, there may be a problem. We have run into several situations in which systems were optimized to show a more favorable backtest. Optimized backtested information is useless.

The most reliable data is a real, operational track record that has an auditable GIPS-compliant record. GIPS (Global Investment Performance Standards) are a reliable and ethical way to assess the performance of a manager’s returns. The standards can be found on the CFA Institute website. There are many firms that provide GIPS-compliant return audits on third-party managers. If a manager cannot provide you with one, the only rational question to ask them is, why?


  • GIPS enable investors to directly compare one firm’s track record with another firm’s record.
  • They include composite presentation, improving transparency by eliminating survivorship biases, misrepresentations, and historical data omissions.
  • The standards evolve to address issues that arise in a dynamic investment industry.
  • They incentivize firms to invest significant time and resources into internal risk-control mechanisms and setting performance benchmarks—the hallmarks of reliable long-term success.
  • To be GIPS-compliant, an investment firm must demonstrate adherence to comprehensive rules governing input data, calculation methodology, composite construction, disclosures, and presentation and reporting.

Source: CFA Institute

What are their emergency procedures?

What happens if their building loses power? Do they have robust contingency planning? Do they have alternative means to execute trades? Are their secondary sites secure? What happens if they lose access to their clearing partner?

We have seen situations as recently as February 2018 in which technical issues caused Fidelity, Merrill, and TD Ameritrade access problems. This is uncommon, but volatile markets create stress on their systems, and it affects the professional money manager just as much as the retail trader, usually at the worst time in the markets. They need to have backup plans in place if there is a problem with their clearinghouse.

Many managers will have on-site battery backups or generators, but we don’t believe this is enough. These generally only supply power for short periods of time and can be unreliable. Secondary sites or cloud-based backups are preferred, as they offer replicated systems in other parts of the country that can be relied on in case of an emergency.

How is management structured, and what happens if someone leaves?

Often there is a single star leader or investment “mastermind” at smaller third-party asset managers. That creates a huge business risk and a reliance on that individual. Understanding the pedigree of key people, what their roles are, and how they would be replaced if they decided to leave is crucial. Having an on-site due-diligence meeting to get to know the principals of the company and their key team members is always a sound idea.

Are they a niche manager, or do they have a wide variety of strategies? There is no right or wrong answer here, but I am always wary of a small team that has many strategies and is trying to be a “jack-of-all-trades” manager. Find out if the manager’s internal resources are well-aligned with their strategic offerings. Do they give the appearance of being stretched thin? Some of the best managers have a niche focus and manage one strategy or a few substrategies with a similar focus. Other smaller and midsized firms have had success with a robust strategy offering. But that obviously requires the talent, research capabilities, technology, and systems to consistently manage a range of differentiated strategies. Make sure you understand what type of firm you are potentially going to entrust your business with.

Why did the manager start their firm? What is their driving motivation?

One of the first questions we always ask is “why did you start the firm?” We tend to get two answers. They either have a deep conviction in their process, or they want to manage a lot of assets. The former will generally lead to the latter. However, we often hear, “We want to be a billion-dollar manager.” That is just code for “we want to get rich.” There is nothing wrong with getting rich, but managers with a deep conviction in their process, whether quickly achieving success or not, will focus more on process development, improvement, and continued learning. Asset growth will find its way to outperforming managers who add true value for financial advisors in the long run.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

Brad Roth is the president and chief compliance officer of Kattan Ferretti Financial LP, located in Pittsburgh, Pennsylvania. He is responsible for the day-to-day management and oversight of client portfolios. Before starting Kattan Ferretti Financial LP, Mr. Roth was an operations executive at a private quantitative hedge fund.