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Disruptive Research: Conducting Efficient Due Diligence For Investments

Christian Armbruester

22 January 2019

The following commentary comes from Christian Armbruester, chief investment officer at , the European family office that has shared a number of its insights with readers of this publication. The editors here are pleased to publish this content and invite readers to respond with comments. Email

The problem with most research and due diligence reports is that they are too long. Filled with endless amounts of data, descriptions and hyperbole, there literally is information overload. Maybe this is part of the trend or the way things are right now generally, but we seem to be drowning in too much data and we need to concentrate on what really matters.

So, let’s start with the obvious: There are thousands of different investment opportunities and strategies in an infinite universe of possibilities. In our database, we track more than 24,000 individual funds, exchange traded funds, managed accounts and direct investments. Clearly, we cannot perform due diligence on all of them. Therefore, a screen is needed to identify which investment strategies warrant further investigation. Much of how you choose a strategy will come down to the performance. However, it is equally important to define the universe according to categories, so that one can also compare so-called apples with apples. Most people look at stocks, bonds and alternatives, whereas we look at different forms of price and credit risk. Either way, most investors will always allocate to the best strategies within a defined universe. 

If you were to compare finding good investment strategies with looking for oil, the first step would be to know where to drill. A quantitative screen within different categories should allow us to look in the right places. Next comes the first verification check point: by looking at marketing materials (including fact sheets or presentations), we can gather more information. In other words, we make sure that some fairly basic things are in place. For example, the individuals running the strategy, what type of experience, how much money are they running (and for how long), what pedigree do they have, are there signs of a good business infrastructure and is the strategy (fund) professionally managed (with credible or known service providers)?

Next comes a phone call with the investment professionals to verify what we have read and confirm whether the managers know what they are doing. The key to this discussion is to stick to understanding why this strategy is making money and in so doing whether these professionals add any value. Put even simpler: if a strategy is making money because of structural, fundamental, or statistical reasons then there is a premium to be had for the risk we are taking. If a strategy cannot demonstrate an edge other than the managers telling us they are “really smart”, then we do not invest.

Getting back to our oil example, we know where the oil is, now what we want are people that can extract it efficiently. We have identified the candidates, done some data checking and had a chat with them to make sure they say the right things. Now we need to verify what they have told us, and this is where the deeper operational due diligence comes in. But again, there is a method to this madness. Most strategies these days come with pre-prepared due diligence questionnaires. They tend to be very good and very thorough, because hundreds of other research analysts have poked holes into any discrepancies; and because professional money managers do not (or cannot) invest in non-professional investment strategies, you can rest assured that the ones they do invest in are very sound (it’s akin to a self-correcting market). There are many professional research firms that simply re-create their own due diligence report from the very information already available. They do this so they can show all the work they have put into their “valuable” reports, which naturally are also very lengthy in nature.

However, all we really want to know is whether what the managers told us is true. That means we need to check the records, talk to people, perform online searches to make sure, for example, that they actually graduated from university, actually worked where they claimed they worked, and do not have any criminal records. All pretty basic stuff, but remember Madoff, the $11 billion hedge fund fraud? His accountant had an office above a kebab shop on Edgware Road. Nothing wrong with that part of town, but you would think that you’d have someone check out these types of things, rather than copying and pasting hundreds of pages in a research report so that it “looked thorough”.

And that’s the thing, efficiency only comes when you focus on what is relevant. Nowadays, with the prevailing technology and scale of the financial services industry, not to mention compliance and regulations, every trade and investment is tracked, double checked and triple reconciled. The value doesn’t come from trying to understand how a hedge fund does trade reconciliations, the value comes from actually making sure the operations do what they say they do (like asking how many trade failures they have had recently). When we buy a car, few of us would try to re-engineer how the engine works. Instead, we rely on the track record of the manufacturer or model history.

Most of what you need to check can be done relatively quickly, but it is imperative that one goes on-site to actually see and feel whether the things that are purported are really true (kebab shop et al). Knowing what to ask is key and most importantly, it is being smart about getting the information that is relevant and not being put off by vague or non-specific answers.

After the operational due diligence has confirmed that all is as it is supposed to be, we can make one final check and that is to meet the portfolio manager. We want to make sure we can work with them for the longer term, to help reduce the time we need to spend performing due diligence on new managers.

By taking a very methodical, logical and quite natural process to get the full picture on things in a very efficient way, we have cut down our due diligence process from several months to a matter of weeks. We are also able to consolidate on no more than a few pages everything that we need to know, verify and understand, which saves us from reading hundreds of pages of information we don’t need. All that remains is that we monitor the performance and behaviour of our chosen investments. Or in other words, we want to make sure we keep the oil flowing for as long as we can.