The History of Investment Manager Due Diligence: Where we Went Wrong and Why from a Webinar on February 18,2010

1. February 11, 2011 Webinar
The History Of Manager Due Diligence
And Where We Went Wrong
Not Much Has Changed, But it Should
Ron Surz, CIMA, MS, MBA The Dark Ages
President, PPCA Inc
President, Target Date Solutions
(949)488-8339
Ron@PPCA-Inc.com
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2. The craft of delivering solutions
60s 70s 80s 90s 2000s
Schlepper/ Manager Asset Trusted
Performance Selection and Allocation Advisor
Reports Due Diligence
The craft of manager due diligence
60s 70s 80s 90s 2000s
Indexes Peer Blended
Indexes &
Custom Peer
Groups Groups

3. It’s a Bad Joke
…each money manager has ready stories about other money
managers with low alphas who snatched clients through clever
marketing. Professor Meir Statman
I have never met a money manager who has performed below
median.
Every manager wins against the right benchmark.
We cannot change what we tolerate. The Madoff mess was
enabled by lax due diligence.
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4. Agenda
 The Issues: Schools of Thought
 Performance Evaluation: Benchmarking
and Significance Testing
 Attribution: Getting Whys
 Proof of Better Living Through Science
 Using What We’ve Learned: Recognizing
Skill, & Portfolio Construction
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5. Schools of Thought
Dave Loeper, President and CEO of Finance Ware
Insufficient value added given the time, energy and money to do
manager due diligence right. The potential benefits of manager
due diligence are outweighed by the costs.
Behavioral Finance Professor Meir Statman, What investors
Want
Investors demand active managers because they want to have
fun, and they’ll pay extra for it. It’s similar to diners choosing
fancy expensive restaurants.
Dr. Frank Sortino, The Sortino Framework for Constructing
Portfolios
Optimize around talent by integrating active with passive. Use
active where you find skill, and passive where you don’t.
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6. Winners and Losers:
Use the right tools to address
the 2 central due diligence questions:
What does this manager do?
Indexes
Does he/she do it well?
Peer Groups
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7. Truths
1. An index is NOT a benchmark, except for index
huggers and indexers. Tracking error is neither risk nor
value added.
2. Custom benchmarks best define what a manager does.
The intent is to capture the People, Process &
Philosophy. Building blocks (indexes) matter a lot.
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8. Dr. William F. Sharpe
“It is desirable that the selected asset classes
be:
Mutually Exclusive (no class should overlap with another)
Exhaustive (all securities should fit in the set of asset classes)
Neither S&P nor Russell indexes
Meet These Criteria
“Determining a Fund’s Effective Asset Mix”, Investment Management Review,
December, 1988, pages 59-69.
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9. Creating Mutual Exclusivity
“Refining Core-Satellite Investing”,
Journal of Performance Measurement, Fall 2010 9

10. Surz Style Pure® Indexes
Core behaves differently than value and growth
Large Middle Small
Value
Core
Growth
Surz Morningstar
1986 1997 2010 10

11. Value-Growth Classification
Price/Earnings Price/Book
 Earnings are a Flow  Book Value is a Stock
Variable (Current) Variable (Historical
Accounting)
 Book values of some
large banks are
grossly overstated in
this financial crisis
“Becoming Style Conscious”, Journal of Investing, Fall 2010 11

12. Whose Style is it Anyway?
Classifying Financials in Q2, 2010
Surz Style Pure® 3-Factor Model = Centroid
Price/Earnings, Yield, Price/Book Price/Book
JPM JPM
BAC BAC
Wells
Wells Citi Citi
AXP UBS UBS
AXP
MS MS
STT STT
NTRS NTRS
RJF RJF
Value or Growth?
Your Style Lens Makes a Big Difference for
Bank of America, Citigroup, UBS, and Morgan Stanley
View your favorite stocks & indexes at:
< Style Scan >

13. Style Index Returns for the
3 Years Ending 2010
2 Russell 200 Surz Style Pure® Large Cap
1 0.6
Value Growth Value Growth
0
Core
-1
-1
-2
-3 -2.4
-4
-5
-6
-7 -6.5
-8
-7.9
-9
A value manager that “Wins” against one index could easily “Lose”
against the other index. Ditto for growth. What does this manager
actually do?

14. Summary: Good Building Blocks for
Custom Benchmarks
 Mutually Exclusive
 Exhaustive
 Dependable classification design
 Regular rebalancing, more frequently than
annual
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15. Winners and Losers
What does this manager do?
Custom Benchmark
Does he/she do it well?
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16. Truths
1. Peer Groups all have a little known bias called
“Classification Bias.”
2. Statistical significance can be achieved over short
periods of time, but not with regressions (“alpha &
beta”). Use Hypothesis Testing instead.
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17. 17

18. CFA Institute
Benchmark Committee Report
•Be wary of peer groups
Classification, composition & survivor biases
•Use custom benchmarks instead
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19. The Wait:
Number of Years to Achieve Significance
Regardless of the Benchmark, It Takes Decades to Exhibit Statistical Significance
160
140
120
100
80
60
40
20
0
A Little Skill Good Skill Great Skill
# of years = (1.35/IR)2 19

20. Test the Hypothesis “Performance is Good” using
Virtual Peer Groups (VPGs): Transforms a
Custom Benchmark into a “Peer Group”
Simulator
Benchmark Construction
Rules
Portfolio
Opportunities
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21. Style Universes for 2010
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22. It’s all about the Future
Attribution: Strengths should
continue and failures are being
corrected
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23. Truths
Knowing why (attribution) is the key, but if the
benchmark is wrong all of the analytics are wrong.
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24. Sample Fund
Lg
Value
Core
Custom Attribution
Lg Growth
Fund Return
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25. Evidence
Sortino Research
 Excess Omega using “best” style analysis
persists: published in Pensions &
Investments
 Desired Target Return (DTR) Alpha can be
and actually has been achieved
The Trone Challenge
 Procedural Prudence vs Substantive
Prudence: Common vs “Best” Practices.
 2005 performance contest
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26. Truths
1) Custom benchmarks best define what a manager does.
Building blocks (indexes) matter a lot
2) Hypothesis testing reveals real success or failure.
Statistical significance can be achieved over short
periods of time by simulating the opportunity set.
3) Knowing why (attribution) is the key, but if the
benchmark is wrong all of the analytics are wrong.
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27. Fine: How Can I Use This?
Demand the Best:
 21st Century investment manager due
diligence. Always change a losing game.
(DOL and NASAA fiduciary requirement)
 Portfolio optimization that blends skillful
active with passive where there is no skill.
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28. Allocating (Indexes)
to Skillful Managers (Benchmarks)
INTEGRATE
Avoid the 4-corner solution
Large Large
Value Growth
Small Small
Value Growth
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29. Coordination is the Key
CORE is the Locksmith
1. Find Skill by Looking Everywhere, not Just Style
Corners. Use 21st Century tools.
2. Allocate to Skill to Maintain Diversification (Optimize).
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30. What will it take?
Advisors must demand that new & improved tools
are used by their due diligence providers.
If we don’t really care, the Loeper school makes the
most sense – don’t waste the money.
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31. We’re all hardwired to resist change
•Attachment bias: Continued reliance on an approach for
emotional reasons, such as “We’ve always done it this way.”
•Cognitive dissonance: The challenge of reconciling two opposing
beliefs.
•Confirmation bias: The natural tendency to accept any
information that confirms preconceived position and to disregard
information that doesn’t support this position.
•Overconfidence: In combination with confirmation bias, the
placement of too much emphasis on one’s own abilities.
•Status quo bias: The tendency to do nothing, even when action is
in order.
•Laziness: Change takes effort. 31

32. The Folly of Common Practice
Common practice sometimes defies common sense.
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33. Bibliography
http://www.ppca-inc.com/WhitePapers/white_papers.htm
http://www.ppca-
inc.com/Commentaries/Commentaries.htm
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34. Questions Please
 The Issues: Schools of Thought
 Performance Evaluation: Benchmarking
and Significance Testing
 Attribution: Getting Whys
 Proof of Better Living Through Science
 Integration: Portfolio Construction
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