A Guest Article By Kamal Suppal
Most would probably agree that tectonic changes are sweeping across economics, politics, business and capital markets. And it is in a rapidly changing world that investment portfolios must continue fighting to bridge gaping funding shortfalls and/or meet spending targets. The new investment paradigm demands the capture of as many idiosyncratic sources of alpha as possible, rather than a repetition of old practices of allocating just to “comfort managers”—large managers with big infrastructures that provide safety in the minds of allocators. These changes calls for democratizing institutional manager research and due diligence beyond the traditional consulting model.
This “democratization” of research and due diligence for a new investing paradigm is also an echo of the newly introduced MiFid II rules (in Europe) that call for separation of investment research from execution where the latter in this context is analogous to strategic investment consulting.
Traditional consultants and their OCIO brethren both tend to gravitate toward larger managers with known brands and big infrastructures, under the guise of “institutional quality,” because even if these firms post mediocrity that likely would not get them or their clients into trouble. Moreover, most consultants today, faced with shrinking operating margins, business succession issues, lean research teams and challenges in attracting seasoned investment research professionals are generally compelled to mitigate any existential threat from a bad investment recommendation by keeping it simple.
Therefore, niche managers are often told that they are “too small”, implying that their size is insufficient for the gate-keepers to scale across their clientele and get more bang for their time and resources. But investors who lack adequate in-house resources and bandwidth to conduct in-depth due diligence on their own often expect their consultants to go into niches where they cannot, especially if they have an appetite but not the means.
Is it prudent then to let a nugget of potential alpha flee from under our noses just because it fails to attract due-diligence resources or lacks someone’s stamp of approval?
Recognizing that the typical consulting model does not lend itself to extensive due diligence on below-the-radar managers, investors should seek an independent 360-degree evaluation of a manager customized to the related investment opportunity. This is quite different from getting just an investment (buy) recommendation on a manager. This is akin to independent reviews sought of financial auditors, independent valuators, third-party administrators and now even ESG consultants.
Once asset owners have defined their targeted “opportunities”, (e.g. capitalize on innovation, exploit distress situations or illiquidity, profit from volatility, etc.) through strategic/tactical asset allocation plans, they should be open to managers big or small, across geographies, capital structures and liquidity spectrums, who can execute well within their opportunity set. This opens a vast array of opportunities outside of just managers on consultants’ “buy-lists” that often pose adverse selection bias.
The current intellectual gap in the institutional marketplace, regarding the sourcing and deep analysis of niche opportunities, is encouraging the emergence of independent investment auditors—each specialty shop with its own forte, e.g. venture, macro, infrastructure, private equity, emerging markets, etc. As pure research and due diligence firms, independent investment auditors research and dig deeper into niche managers and opportunities (not on any buy-lists) beyond simple screens, filters and boiler-plate due diligence questionnaires and templates.
An unbundling of consulting dollars to pay for best of independent research ideas and due diligence, to gain an instant head-start for professional trustees with investment acumen, is the need of the hour. For those asset allocators confined to traditional ways, this might seem a utopian fantasy; for those progressive-minded, reoriented to navigate a new investment world, specialist independent investment auditors are on the horizon. This would allow investment trustees to take more ownership of their own investment decisions and support their convictions as exemplified by many an endowment, corporate pension and insurance company plan sponsor.
Kamal Suppal, CFA is Chief Investment Auditor of Boston-based Emerging Markets Alternatives, an independent investment audit firm specializing in the research and due diligence of alternative strategies in emerging markets.