The game “twenty questions” implicitly divides the world into three parts: animal, vegetable, mineral. Greek philosophy has its tripartite soul: intellect, spirit, and appetite..Dorothy Gale of Kansas had three companions each representing one of those same three components. German philosophy had its dialectical movement: thesis, antithesis, synthesis. A Presidential candidate recently demanded the abolition of three cabinet departments, though he could only name two. Tripartite divisions clearly appeal to something deep in the human soul.

Merlin Securities, the prime brokerage services and technology provider, has confirmed this psychological fact in its new white paper on “investor due diligence,” offering investors a road map through a process that has become “very data driven and time intensive, requiring greater transparency and granularity than ever before.” With remarkable consistency, Merlin keeps breaking issues down into three parts.

Due diligence itself proceeds in three stages: strategic, qualitative, and quantitative. That is:  first an investor must decide what kind of strategy it is to which he wants exposure, and generate a list of managers who practice that strategy. Thereafter he can focus on each firm on that list looking at each of the three (qualitative) components of management.

Three Parts to Quality

1. People: An investor will need to know who the key individuals at a fund are and what experience and track record they have. This will entail contacting these figures’ prior employers and associates to determine their roles and contributions in the other entities to which they’ve contributed.
2. Process: Management has to tell a story, about how it generates investment ideas, researches their implications, constructs a portfolio, and manages risks.
3. Philosophy: In the course of that story telling, management should be able to explain why it is different from other funds, even other funds that follow the same strategy or mix of strategies. It should be able to tell the investor about its distinctive philosophy.

These three elements between them “comprise the backbone of all funds and are the source of their performance.” But the quantitative portion of due diligence must follow, as a matter of confirming (or falsifying) that story with numbers.

Three Overlays of Quantity

This portion, too, may be divided into three parts or “overlays” as Merlin calls them: performance; risk; attribution analysis.

The performance overlays itself begins with the three ways in which a fund traditionally breaks down the performance data for potential investors: cumulative return (the compounded return since the formation of the fund); 12-month rolling return; and average monthly return. Averages have the advantage that they are “simple to understand and set a month-to-month return expectation.” Each of these three sets of numbers should be graphed against pertinent benchmarks.

The white paper provides three sample charts on how these return figures may be displayed, such as the following:

The second overlay is risk. Without looking into the issue of risk, after all, it is impossible to tell whether performance numbers represent alpha, rather than a leveraged beta play.  Further, exposures as Merlin points out “vary significantly over time, so single point references often do not show the complete picture.”

The conventional displays of exposure use long/short or net/gross numbers. Merlin urges investors to go beyond this and receive “advanced analytics of delta-adjusted exposures and beta-adjusted exposures” as part of their due diligence. They must be aware of the way in which delta-adjusted exposure can differ drastically from notional exposure, as illustrated below, in a graphic taken from the white paper.

Aside from exposure by any metric, there are other approaches to understanding risk. There is, for example, drawdown analysis. Due diligence must include a look at the depth of the valley between the peaks of monthly performance. This is “simple to understand and compare across peers, and provides investors with a feel for risk over the life of the fund.”

The third and final overlay is attribution analysis. Assuming the performance is satisfactory and risk well managed, potential investors will still want to know just where the results come from. Do they come from specific sectors? The work of specific managers and/or analysts?

Conclusion

In concluding, Merlin addresses investors as the second-person “you,” and asks them to “make sure that you have the tools in place to meet the current demands of today’s sophisticated investor.” As the Scarecrow might say, you can use your brain to think of things you never thunk before.

At the same time, you should not forget the old-school fundamentals, the investment story and the impressions the people who want to manage your money convey when you and they are face to face.