Most pensions, endowments and foundations do not pick individual stocks and bonds themselves. They hire external investment managers, often several in each asset class, and spend much of their time deciding whom to hire, how much to allocate and when to make changes. Because a poor choice can affect results for years, institutions use a structured due diligence process before committing capital.
Start with the role in the portfolio
Good manager selection begins with the portfolio, not the manager. The investment committee first decides what job needs to be filled: broad market exposure, a specific region or sector, a diversifying strategy, or a private-market allocation. That role determines the benchmark, the acceptable level of risk and whether a low-cost index approach could do the job instead of an active manager.
Investment due diligence
Investment due diligence asks whether the manager has a clear, repeatable way of investing and the people and resources to carry it out.
- Philosophy and process: what the manager believes about markets, how ideas are generated, how positions are sized and when they are sold.
- People: the experience and stability of the investment team, how decisions are made, and how key people are retained and paid.
- Track record in context: past performance is examined against the right benchmark and over full market cycles, with attention to whether results came from the stated process or from luck, leverage or style drift. Past results never guarantee future performance.
- Risk management: limits on concentration, leverage and liquidity, and how the manager behaved in difficult periods.
- Capacity: whether assets under management have grown beyond what the strategy can handle well.
Operational due diligence
Many institutional losses have come from operational failures rather than poor investment calls, so operational due diligence is often run as a separate review with the power to veto a hire. It typically covers:
- Independent custody of assets and the use of reputable administrators and auditors
- How securities are valued, especially hard-to-price assets
- Trade processing, cash controls and segregation of duties
- Compliance programs, regulatory registrations and history, which can be checked through public sources such as the SEC's Investment Adviser Public Disclosure site
- Cybersecurity, business continuity and key-person risk
Fees, terms and alignment
Institutions negotiate and compare management fees, any performance fees, hurdle rates and expense pass-throughs. They also review liquidity terms, lock-ups, reporting obligations and the legal agreements governing the investment. Alignment of interest, such as the managers investing their own money in the strategy, is often considered a positive sign.
Making the decision
Findings are usually summarized in a written report for the investment committee, comparing finalists on the same criteria. Documenting why a manager was chosen, and what would cause the institution to reconsider, makes later reviews more objective.
Ongoing monitoring
Due diligence does not end at hiring. Institutions review performance against benchmarks and peers, watch for changes in people, process or ownership, and repeat operational reviews periodically. Many also define in advance the events that trigger a formal review, such as the departure of a lead portfolio manager.
Applying the ideas as an individual
Individual investors choosing funds can use a simplified version: define the role a fund should play, compare costs, read the prospectus, understand the strategy and risks, and check the adviser's registration and disciplinary history on Investor.gov or FINRA BrokerCheck before investing.
This article is general educational information, not investment, tax or legal advice, and it is not a recommendation to buy or sell any security. KazimirInvestmentsLLC.com does not provide investment advisory or management services. Check current rules with official sources such as Investor.gov, the SEC, FINRA or the IRS, or consult a licensed professional.