Frequently Asked Questions - Due Diligence and Manager Selection
There is no hard and fast rule, but our willingness to stick with a stock picker is heavily influenced by our confidence in their skill and enthusiasm for being a part of Litman Gregory Masters Funds. Our regular monitoring keeps us up to date on the manager’s portfolio and the reasons behind good or bad performance. And, based on our contact we are always assessing whether the reasons we hired the sub-advisor in the first place remain valid. However, if for any reason our confidence in the sub-advisor comes into question we will typically do a thorough update of our due diligence. This could be triggered by performance that is poor for an extended period of time (exactly how long will depend on the magnitude and the reasons for the underperformance), or other more subjective factors that arise from our ongoing monitoring. Due diligence updates go beyond our regular ongoing monitoring, and may involve another site visit and round of interviews. If we come away from this review process feeling highly confident that the reasons we liked the stock picker in the first place are still intact, we will stick with the manager even in the face of several years of underperformance. If our confidence has lessened but is still strong we may weigh the alternatives. If our confidence is not high then we will begin to search for a replacement.
It is worth noting that concentrated portfolios tend to be more volatile than diversified portfolios. Sometimes a stock picker is too early in buying a stock, resulting in a period of weak performance, but ultimately the stock picker successful over the long term. And even highly skilled stock pickers make mistakes. So we expect all our sub-advisors to have occasional periods when performance is poor. Fortunately, the diversification in each Litman Gregory Masters Funds significantly mitigates the risk from any single manager, and so far the funds have experienced many more positive manager performances than bad manager performances.
As is often the case in our industry, the managers are not under long-term contracts. This means that they could walk away or we could fire them at any point. Practically speaking, if the relationship is going well and they are doing a good job, we will want to keep them and they will want to stay. If that is not the case, we wouldn’t want to keep them and we certainly wouldn’t want a sub-advisor to be contractually forced to run money for Litman Gregory Masters Funds. To date we have removed several sub-advisors though it is obviously our goal to make good long-term hires so that removals are rare.
Our sub-advisors may be motivated by one or more factors, including:
- The respect for Litman Gregory they’ve gained over the years as a result of the initial and ongoing due diligence we have done on their firm. This influences the confidence they have in our firm as a strong potential partner.
- Their confidence in the Litman Gregory Masters Funds concept.
- A number of our sub-advisors have expressed a real passion for concentrated investing that is reflected in their excitement in getting the opportunity to do so in a real world portfolio. In most cases, this is not an option in the separate accounts or the mutual funds they run.
- The prestige of being part of a Litman Gregory Masters Funds group.
- The opportunity for friendly competition against the other Litman Gregory Masters Funds sub-advisors.
- The revenue stream from the Litman Gregory Masters Funds account.
When we hire stock pickers as sub-advisors for a Litman Gregory Masters Funds, it is our objective to apply an extremely high standard and to be exceptionally thorough in our research of the stock-picking team, their process, their execution, the culture and business objectives of the organization and their enthusiasm for being part of Litman Gregory Masters Funds. In meeting this objective, we hope that each sub-advisor we hire will be with the fund for the duration of his or her career. The conviction we gain from this process also makes it easier for us to ride through the occasionally bad periods of performance that even great stock pickers experience. Despite these efforts, sometimes events outside our control force a change—such as when Bruce Bee (one of the original Litman Gregory Masters Funds International managers) died. The other reason for a change would be if our opinion changes with respect to a manager’s ability to deliver good performance.
When we believe it is in shareholders’ best interests to make a change it is almost always because of one or more of the following reasons:
- We believe we were wrong about the stock picker’s skill.
- We realize that the stock picker is not at his or her best running a highly concentrated portfolio.
- Something has changed at the stock picker’s organization that reduces our confidence in the ability of the stock picker to perform well going forward.
- We come to believe that the stock picker is not adequately attentive to the Litman Gregory Masters Funds portfolio.
Fortunately, we have not had to make many sub-advisor changes over the years across the five Litman Gregory Masters Funds funds.
There are two ways we can assess this. The objective way is to compare the sub-advisors’ performance for Litman Gregory Masters Funds against other portfolios they run. This is particularly telling if the other portfolios are significantly more diversified. When we hire sub-advisors it is with the objective that they be able to deliver higher long-term returns with their concentrated Litman Gregory Masters Funds portfolio than they would in their more-diversified portfolios. (We understand that over shorter time periods this won’t always be true.) The subjective way to assess whether the Litman Gregory Masters Funds portfolio reflects the sub-advisor’s best thinking is through our contact with them, including stock discussions, which provide us with a window in which to assess their enthusiasm for and respect for the relationship with Litman Gregory and Litman Gregory Masters Funds.
While the basic due diligence process is the same, we will additionally assess the stock picker’s comfort with running a concentrated portfolio and their enthusiasm for being part of Litman Gregory Masters Funds. Our selection criteria for hiring Litman Gregory Masters Funds sub-advisors are the most demanding.
It is easiest to evaluate this if they already have experience and success running a concentrated portfolio. For example, Mason Hawkins and Bill Nygren have both run concentrated funds. For stock pickers who have not run a highly concentrated portfolio, we ask them to put together a “mock” portfolio to reflect the stocks they would hold if they were already running a Litman Gregory Masters Funds portfolio. We then discuss the portfolio so that we can understand the criteria and the process used to identify the highest-conviction ideas and to build the portfolio. An important part of the process is a detailed discussion of the stocks in the portfolio with the objective of gaining an understanding about why they have stronger conviction that these holdings will be successful. We then make a qualitative assessment as to whether the manager has good reasons for their varying conviction levels between stocks (we may also discuss stocks they hold in their more diversified portfolios) and whether they are genuinely more confident in some holdings than others.
We have been conducting due diligence on stock pickers since the founding of our firm in 1987, so we are already very familiar with many industry veterans. Also, by being in the industry for many years, we are familiar with many others by reputation. Aside from managers we already know, we also search industry databases and we are often contacted by investment management firms interested in running money for Litman Gregory Masters Funds. Finally, we also query stock pickers we respect for recommendations. Once we have identified a candidate we conduct extremely thorough due diligence to determine whether the stock picker is worthy of running money for a Litman Gregory Masters Funds.
We believe that superior investment managers exhibit most of the following characteristics:
- A well-defined process that is executed with discipline. There are many intelligent people in the investment business, but based on our many years of researching stock pickers we believe that great stock pickers have a process that is usually explicitly outlined and faithfully followed rather than intuitive. This helps to reduce decision errors that result from mental shortcuts born from overconfidence or sloppy work.
- The passion for stock picking that results in the drive to work harder and more creatively in order to gain an edge. The investment business is intellectually stimulating but hugely demanding. Successful investors usually have a love for the business that allows them to make lifestyle sacrifices as they pursue their overriding passion for stock picking.
- The confidence and ability to think and act independently. Great stock pickers tend not to be influenced by consensus views. Hand in hand with thinking independently is a long time horizon and a high degree of patience. (They are willing to be wrong at least temporarily.)
- Intellectual honesty. Great stock pickers are honest about their circle of competence and are aware of their biases so that they can be objective in their analysis. While confident, they are also able to recognize and admit mistakes and learn from them so they can go on to fight another day.
- Experience and an above-average long-term performance relative to an appropriate benchmark index and peer group. Litman Gregory measures investment manager performance against performance composites made up of other stock pickers using a similar stock-picking style and market capitalization. Litman Gregory maintains its own database and has developed proprietary software to measure and analyze performance over various periods.
- A focus on the job of stock-picking and portfolio management. Litman Gregory seeks investment managers who have attempted to mitigate non-investment distractions by delegating most business management and marketing duties.
- An investment process that lends itself to concentrated investing. Though we don‘t require that a stock picker have experience in running concentrated portfolios, they must have a process that lends itself to concentrated investing to be considered for a Litman Gregory Masters Funds sub-advisory position.
- A high level of enthusiasm for being part of Litman Gregory Masters Funds. We require that any Litman Gregory Masters Funds sub-advisor be enthusiastic about the opportunity.
We have extensive experience evaluating investment advisory firms using the above criteria, and we believe that each of the investment managers selected to participate in the funds exhibits most of these qualities.
We watch their trades on a regular basis to confirm that the account is being run as we expected based on our due diligence. In addition we have regular contact with the sub-advisors to discuss various aspects of the portfolio, including individual holdings, and we stay updated on developments at their firm and with the analyst team.