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Stefan Whitwell, CFA, CIPM Chief Investment Officer

March 26, 2013 MANAGER DATA, DUE DILIGENCE AND SELECTION PROCESS RISKS There are 10 specific risks that the portfolio manager needs to manage. 1. Using too many managers: The portfolio will produce “Beta” -- and investors will only want to pay commoditized fee levels associated with index funds; what investors need, however, is “Alpha”. 2. Using too few managers: Idiosyncratic risk will be excessive leading to big losses. 3. Believing the DDQ Narrative: Those of us who worked on trading desks on Wall Street can attest that most fund managers trade quite similar to most other fund managers, even though every single DDQ ever written makes specific claims of being different (hence the frequent use of the word “proprietary”). Note: often the core trading is similar, while relatively insignificant factors are in fact unique. If everyone is driving in the same lane in the same direction, it is not a material difference if you hold the steering wheel with one hand, two, left or right. 4. Managers appear different when in fact they are similar: Everyone claims to be different, but statistically we know this is not true. If we assume that the portfolio is diversified, when it is not, then the investors will likely face a nasty surprise. 5. Undisclosed policies: We have seen situations where, for example, a manager offered their program denominated in different G-7 currencies which implied that the difference in return between the different units was merely the monthly currency effect. It turns out that they do not have a systematic method for converting returns and improvise based on their market views, which presents another risk and furthermore, their method of currency conversion is not disclosed in any written materials. We have also seen examples where a historical return table published by a major investment bank failed to disclose that the volatility target for that program changed dramatically mid-stream and caused a big change to subsequent data. It takes a lot of work to make sure one really understands the advertised numbers. 6. Using non-homogenous data in analytical comparisons: The major FX platforms charge different fees and require the managers to trade at different volatility-levels so that they are incomparable. In addition, we have seen situations where a platform (run by a large investment bank) did not distinguish between actual returns and hypothetical returns for one or more managers, which raises a whole set of other questions. Furthermore, some managers disseminate gross returns but will provide net returns upon request; others use net returns. And lastly, different managers and platforms report their returns in different currencies. Many people in the business try and “short-cut” the work involved by paying for access to huge databases that provide data on large numbers of sub-managers. While convenient, those databases do not have complete disclosure, manager by manager, of how those data were calculated and unless you source original data, you have no means of verifying its accuracy. As they say in engineering, “trash in, trash out”. Analytical comparisons, such as manager selection analysis, requires homogenous data. Empirical Solutions, LLC
815-A Brazos Street | Suite 491 | Austin, Texas 78701 | 877.936.3372 | stefan@empiricalresults.net

It is important to calculate the ratios firsthand since it is the only way to know. If you re-calculate the ratio on a net basis. CFA.down over 50% in five months (down 25% in one month). However. that proudly advertises its Sharpe Ratio. since it was so much lower. 10. Clearly that manager did not have a sufficient risk-management system in place. relying on statistics produced by third party databases or by the managers themselves is risky business. the result is shockingly lower. Due to the time it takes. LLC 815-A Brazos Street | Suite 491 | Austin. Over-reliance on Past Data: Historical data is useful -. Feeling safer with long track records: We recommend using the last five or six years worth of data. This leads the users of such platforms to feel safe. which it calculates using gross returns. so much so. the difference between gross and net returns can be substantial especially taking compounding into effect for longer periods of time. we got in touch with the manager to make sure that our calculation was correct. most people will believe that statistic at face value and never do the work to calculate it for themselves.0 which is impressive and true. Since they are big and have a track record in excess of a decade. for example. Forming analytical conclusions based on gross data: Many of the graphs and much of the performance data published by platforms (manager summary sheets) use gross returns (returns prior to subtracting fees).3372 | stefan@empiricalresults. how the calculations were made.even though there is plenty of data that shows the fallibility of this approach. They proudly advertise a Sharpe Ratio in excess of 1. few do this. it is human nature to feel safer with managers that have long performance records.! Stefan Whitwell. “do not judge a book by its cover. with certainty. There is a popular sub-manager. which is decidedly net of fees. Mathematically. Linear interpolation seems innate to human nature. That said.” However. as they say. however.936.” 9. Empirical Solutions. 8. A seasoned professional with first-hand forex trading experience can also use it to verify gaps and holes in the narratives in written documentation that can identify risk issues not otherwise disclosed. most professionals regularly use (sometimes required to be used by regulators) disclaimers stating something to the effect that “past performance is no guarantee of future results. Unfortunately.net . Texas 78701 | 877. One well known manager comes to mind that manages several billion dollars. CIPM Chief Investment Officer 7. Therefore. most portfolio managers and investment committees behave exactly the opposite -. in practice. Keeping this irrational habit in mind. When we did our own calculations. so that past data is used constructively. it is vital that the manager selection process have a logical framework by which managers are picked. but not relied upon with false confidence. big does not necessarily denote better and in mid-2012 there was a spectacular example of the fallibility of this big firm’s analysis: one of the managers that was approved by both the investment bank and the consultant had a spectacular blow-up -. and the work required.from it we can learn a lot about the manager. in one of the great ironies of the investment management business. we discovered that the first three years of data were spectacular and the last seven years was below average. This inflates the returns and misrepresents the actual client experience. Believing that big-name consultants’ advice is safe: One of the biggest currency platforms today uses as one of its selling points the fact that it hires a major and bigname consulting firm to do intensive due-diligence on managers before they are allowed to join their platform.

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