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I’m working with the due diligence department of a major investment firm that wants to use my fixed income attribution model to screen bond managers for consideration into their product platform, as well as for performing ongoing due diligence and monitoring of their existing managers. They like the model’s robust analytics and drill down capabilities along with its minimum data requirements. They expect to implement the model at the sector level, since it’s unnecessary to get issue level data to perform the analysis. So, they began contacting their existing managers, asking only for the characteristics of each sector: coupon, price, duration, weighting and return. To their surprise (and to mine) they were denied this data from one of the largest bond managers around, citing difficulties in getting the data at first, and then switching their story to the potential legal problems with disclosing this data, since this information is not provided to every investor in their fund. They went back to the bond manager, clarifying that they would not be violating any rules in distributing this data, since the SEC rules only apply to individual bonds and not to the total portfolio or to the major bond sectors. For example, which investor would be harmed because the manager had noted in a report that the average coupon of the corporate sector was 3.5%? Seems rather silly, no? This appears to be more of an unwillingness to provide the data, rather than an inability to do so. So, let’s consider this in the broader context of the legal concept of “informed consent” which requires providing potential investors with all the information they need to make the best decision that is in their own best interests. And how can an investor do this when managers are unwilling to provide general information about the major factors and parameters of their funds? I’m told that one would be hard pressed to get returns by sector from equity managers, so that it’s not simply the bond managers who are so seemingly recalcitrant. In a post-Madoff age of increased disclosure and due diligence, it seems that fund managers should be required to disclose the major characteristics of their fund so that investors can perform their own analysis and see whether the managers’ claims of the sources of risk and return are justified. It’s not enough to accept a manager’s simple attribution analysis as adequate due diligence into the investment process. Hopefully we have learned this from the Madoff scandal, and hopefully the fund managers will recognize their responsibility to provide greater transparency into their investment process – starting with providing simple data summaries needed for due diligence staff to corroborate the managers’ claims. This could be a “win-win” for everyone, but right now it’s just a dead end.
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Steve, thanks for sharing this case and articulating the issue of transparency. The practical solution, of course, is for the manager in question routinely to include the minimal sector-level data your client requested in the monthly reports that the manager presumably sends all investors. If doing so would entail a costly effort to redesign the client reports and pipe in the data, then the manager could at least add a sentence to the effect that sector-level weights, coupons, prices, durations and returns are available upon request. It seems to me, however, that there may very well be underlying issues of data management and quality (for instance, the manager may not be confident that the month-end characteristic data are sufficiently accurate for external reporting). The difficult question for your client—difficult because it means weighing certain transition costs against an uncertain increase in downside protection—is whether their existing manager’s unwillingness or inability to honor a reasonable request for due-diligence information that has no competitive value is grounds for terminating the relationship. If nothing else, your client might seriously consider conducting a round of operational due diligence (ODD) on this manager. Stone House Consulting does not conduct ODD (we limit ourselves to helping managers prepare to undergo ODD) but other consulting firms can assist your client's due diligence department very capably.
ReplyDeletePhilip: Thanks for your suggestions. You make two important points. In the irst, the manager may not be confident enough in the data to release it to the public. If so, the manager can't have any confidence in the performance results in aggregate, since the total fund return is only as good as the data for the individual sectors and issue holdings. Second, if the manager has no ability to examine the portfolio by basic groupings such as sector, then one would have to question whether the manager has any control over the investment process at all. Either of these cases seems to me to be grounds for dismissal, because if the manager is not in control of the investment process - for whatever reason - then the client potentially faces a situation where risk is not under control. That's when disasters happen.
ReplyDeleteAs you say, there may be no competitive advantage in having control and transparency regarding data - at least from a trading standpoint. But from a client relations basis I think this may be an area of tremendous advantage. Who would you rather invest with: Manager A who is unwilling/unable to provide the data to corroborate the investment process or Manager B who provides complete transparency about what's in the portfolio and how the portfolio is structured? For my money, I'll invest with Manager B every time. If you don't have transparency, then you don't know what's in the portfolio and you can't know what risk you're taking. That's simply not prudent. As prudent investors we must require transparency. Perhaps the best way to do this is to start voting with our feet with the managers who lack transparency.