CAIA L2 - 8.3 - Investment Process Due Diligence Flashcards
Describe and compare
Quantitative due diligence
and
Qualitative due diligence
8.3 - Investment Process Due Diligence
Quantitative due diligence
is used to evaluate measurable outcomes for asset managers, including
* track record,
* investment returns,
* risk,
* correlations, and
* changes in AUM.
Qualitative due diligence
is used to focus more on intangibles like
* asset management experience and staffing,
* integrity and culture,
* firm structure, and
* how alpha is generated (understanding how a fund manager will achieve alpha).
BOTH IS IMPORTANT
Events like the Madoff scandal in 2008 have changed the mindset of investors, as they now look to understand not only the numbers but also the strategies and sustainability of those strategies.
8.3 - Investment Process Due Diligence
Compare
3 categories
of activities
in managing a fund
8.3 - Investment Process Due Diligence
-
investment activities
investment decisions and front office activities -
operational activities
Direct support to investment activities: tasks pertaining to data, records maintenance, or reconciliations -
business activities
Indirect support to investment activities: HR, IT
8.3 - Investment Process Due Diligence
Explain
Costs of
fund Due Diligence
8.3 - Investment Process Due Diligence
The proper due diligence
of reviewing a fund manager
is estimated to take:
75–100 hours
$50,000 and $100,000 = cost per fund, at a minimum
8.3 - Investment Process Due Diligence
Define
Investment Strategy
(or mandate of a fund)
and
list the information provided
8.3 - Investment Process Due Diligence
Investment strategy
refers to a set of
* goals,
* processes, and
* principles
used to create or change the investment portfolio
should provide:
* current portfolio composition listing (including the various securities and markets),
* the amount of leverage and derivatives used, and
* position size limits and
* risk exposures limits.
The strategy should also describe additional items:
* investment team,
* the relevant benchmark(s),
* the manager’s strengths and areas of expertise, and
* how the investment ideas are generated
The actual and stated investment strategy may differ due to
* strategy drift (style drift) = change in investment strategy due to deliberate decisions,
* operational problems, and
* fraud,
all of which are problematic.
8.3 - Investment Process Due Diligence
Define
fund capacity
8.3 - Investment Process Due Diligence
limit of AUM (assets under management)
that ensure the strategy can be executed properly
Limiting the influx of capital is important because it avoids dilution of return opportunitites
8.3 - Investment Process Due Diligence
Complete
The top executive
responsible for the
investment process is the ___
8.3 - Investment Process Due Diligence
chief investment officer (CIO)
8.3 - Investment Process Due Diligence
Define
investment process
and
investment process risk
8.3 - Investment Process Due Diligence
Dica: “PROCESS CIM”
Investment process
generally encompasses
* creating,
* implementing, and
* monitoring
investment decisions
’–
Investment process risk is the risk of:
* errors and
* incorrect decisions, policies and procedures
in the front office
=> is caused by unsystematic risks related to the fund manager’s business activities
and
it can be magnified by market turbulence
=> can be identified by quantitatively analyzing past performance (compare with indices)
8.3 - Investment Process Due Diligence
Explain
how managed accounts
can minimize conflicts of interest
between manager and investor
8.3 - Investment Process Due Diligence
managed accounts provide:
* more fund transparency (for investor)
* enhanced control and monitoring
* less risk of unethical behaviour
Disadvantages to manager:
* lack of control over fund data
* risk of leakage of proprietary information
8.3 - Investment Process Due Diligence
Identify
Advantages of
portfolio information aggregators
(risk aggregators)
8.3 - Investment Process Due Diligence
Third parties
(from managers point of view)
who gather and analyze information on private investments
fund managers provide their funds information
to risk aggregators,
who then provide summary info to advisers:
* beta
* leverage
* risk
* derivatives
They can also run scenario analysis and stress testing
8.3 - Investment Process Due Diligence
List
6 Risk Alert Observations on:
* Asset Values and Due Diligence (2)
* trends in due diligence (4)
8.3 - Investment Process Due Diligence
2 Risk Alert Observations on Asset Values and Due Diligence
1. More use of third-party verification (DD of advisors on main service providers)
2. More reliance on transparency reports (NAV, custodian identification, % with independent custodians, % valued by external adm, fair value measurements)
4 Risk Alert Observations on trends in due diligence
1. More detailed quantitative analysis and risk measurement (1- bias ratio (suggests mkt manipulation, return distribution inconsistent with competitive markets), 2 - serial correlation, 3 - skew)
2. More use of quantitative analysis in investment decisions (returns make sense given the manager’s investment strategy?)
3. Greater importance of external dealer quotes for valuations (vs internal valuations)
4. Avoiding ambiguity in valuations, performance reporting, and measurement
8.3 - Investment Process Due Diligence
Complete
Market risk
primarily reflects the
risk of portfolio losses due to _______
8.3 - Investment Process Due Diligence
changes in systematic and asset-specific factors (unsystematic)
(due to changes in market prices and market interest rates)
‘–
market risk =
the portion of an asset’s total risk that can be attributed either to
changes in the value of the market portfolio
or to a
general market return factor
‘–
In other words, the more specific definition says that market risk is the same as systematic risk.
8.3 - Investment Process Due Diligence
List
3 Key Risks
in a
Risk Review
8.3 - Investment Process Due Diligence
- Short volatility risk (ex: short straddle) - arises from positions in volatility derivatives including writing call or put options and holding positions in other volatility derivatives that are negatively correlated to volatility levels. Or from uncovered short positionsin calls or puts, especially out-of-the money options
- Counterparty risk (risk of default)
- Short selling risk (risk of short squeeze)
8.3.6 - Investment Process Due Diligence
List
4 warning signs pertaining to
investment
4 warning signs pertaining to
risk management
8.3 - Investment Process Due Diligence
4 warning signs pertaining to investment:
- Opaque manager - Lack of willingness by the manager to be transparent
- Returns incongruent to strategy - Investment returns are incongruent given the investment strategy
- Unclear process - An investment process that is unclear
- Inadequate controls and segregation of duties
4 warning signs pertaining to risk management:
1. Overconcentration in certain investments
2. Uneducated staff - Investment staff not possessing required knowledge
3. Style drift - Investment strategy drift
4. Complicated Investment descriptions - Investment descriptions that are unnecessarily complicated or lack transparency
8.3 - Investment Process Due Diligence
List the warning signs that a fund has or may soon experience strategy drift
- Increased leverage
- recent fund underperformance
- increased competition in the markets leading to crowding out of investment opportunities by other investors.
All these factors indicate that fund managers may want to generate higher returns to compensate for adverse market factors and fund underperformance
LO 8.3.2
Synergistic risk
Synergistic risk (or synergistic risk effect) reflects the larger combined impact of two or more risks than simply the sum of those separate risks.
Eg: This could happen when the number of operational errors is positively correlated to the volatility level of market prices.
LO 8.3.6
