Thursday, January 28, 2016

Forward Looking Due Diligence

One important skill we try to teach financial advisors is how to do forward looking due diligence on money managers and investment strategies.  Backward looking due diligence looks at what a manager or strategy did in the past and assumes, usually wrongly, that past performance will persist.  It is the path of least resistance as it is easy to just look at a stream of returns.  Forward looking due diligence tries to figure out whether past performance will actually persist into the future. 

Forward looking due diligence involves answering a couple of key questions:

1. How was the past performance achieved?
2. Why will it persist into the future?
3. And, in the case of a money manager, how will you change your strategy when market dynamics change?

As an example, lets say we are going to do due diligence on a large cap growth money manager and it is March 1, 2000.  If we do backwards looking due diligence all we would do is look at past returns and call it a day.  The manager would have had stellar returns from 1995-2000 and we would make the assumption that they would persist.  Of course we would have been horribly wrong as the manager would have tanked from 2000-2002.  Forward looking due diligence would have sniffed this out by answering the key questions:

1. How was the performance achieved?  You don't need to know the intricacies of the manager's strategy or how they pick stocks.  The answer to this question is simple, large cap growth stocks went up like a rocket ship in the late 1990's.  Since this manager owned large cap growth stocks they rode the market up. 

2. Why will this persist into the future?  Here is the problem.  Growth stocks earned about 30%/year for five years.  That's great but long term returns on stocks are closer to 10%.  Since we know markets mean revert it is safe to assume that not only can't the manager return 30% a year, they also need some losses to get back to more normal average returns.

3. If market dynamics change how will this manager's strategy change?  Here is another problem.  If market mean revert it is safe to assume that at some point we would need to see a bear market.  Since this is a buy and hold money manager they ride the market up, and they ride the market down.

Forward looking due diligence would have failed this money manager on two out of the three questions and it wouldn't take any advanced financial knowledge to figure this out.

Now lets say we are looking at a tactical manager who uses a simple strategy of buying the S&P 500 when it is above its 200 day moving average and selling below.  This strategy would have a very strong backtest most likely showing returns equal to buy and hold with less volatility.  The answers to the three questions would be as follows:

1. How was the performance achieved?  It was achieved because over the intermediate term markets trend.  This is based on psychology and the fact that once the smart money has started to buy or sell something it takes the dumb money a long time to join in.

2. Why will this persist?  Again since this is based on psychology the performance will persist, but we have a small problem here.  Since the manager uses only one methodology there will be times when it cycles in and out of favor, and when it cycles out of favor it can cycle way out of favor.  The performance will persist but it might not be ideal.

3. If market dynamics change how will this manager's strategy change?  This is the make or break question here.  Since we know the strategy will cycle in and out of favor and market dynamics could change to the point were it cycles out of favor more than it cycles in, it is very important to know if the manager is willing to improve their strategy if need be.  If the answer is no then it is time to move on.

Most of the biggest investment mistakes are made because investors only use backward looking due diligence to evaluate opportunities.  Forward looking due diligence can avoid many of these mistakes.

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