In order to address the question of whether or not you should perform operational due diligence as part of your process to evaluate an investment manager, a broad analysis of the primary 
underlying risks is helpful. There are two main types of risk that investors need to assess: investment risk and operational risk.
Investment Risk
Investment risk is the risk that the actual return on an investment will be lower than the investor’s expectations. The risk is inherent to a manager’s strategy. Investment plans often manage investment risk by focusing on several key factors, including:
- Tactical allocation
- Balancing risk between various asset classes
- Choice of investment structures
Additional investment risk is often taken with the expectation of receiving additional investment returns.
Operational Risk
Operational risk is the risk that the way the investment manager conducts its operations and business could lead to lower investment returns. It includes many qualitative elements such as an investment manager’s internal controls, design and implementation of systems, and oversight of employees. Taking on additional operational risk is never expected to improve returns. For this reason, operational risk is an uncompensated business risk.
The following operational items are things to watch out for:
- Investment managers operating outside of their mandates
- Ineffective transaction controls
- Weak reconciliation procedures
- Concentration of authority in one or a few individuals
- Inappropriate attitudes toward risk management
- Lack of checks and balances
It is difficult to anticipate operational risk. Because human error is unpredictable, weak controls or sloppy systems are difficult to price into the risk calculation. Investors, therefore, must assume that human error will be prevented by tight controls in the manager’s systems, in order to rationalize using a manager.
How do Investors Assess and Manage Risk?
Investors assess risk by understanding the investment strategy and determining how it fits into the overall asset allocation model, and by using consultants and other professionals to help provide additional guidance. Sometimes this includes a detailed analysis of returns in different environments and other statistical measures.
Operational risk is impossible to assess from investment returns alone or other purely quantitative measures. This risk is best assessed by performing operational due diligence, which typically addresses the following:
- Trading processes
- Valuation
- Investment portfolio accounting
- Compliance (internal and external via regulators)
- Cash management
- Reconciliation procedures
- Performance measurement
- Service providers used
- Financial strength of the investment manager
- Business continuity planning
- Counterparty risk management
Operational due diligence allows for a deeper understanding of an investment manager’s policies and procedures and whether they are designed to minimize these types of uncompensated risks.
Objectives of Operational Due Diligence
Although the core objective of operational due diligence is to provide investors with information that helps them make investment decisions, the process impacts managers as well. The objectives of operational due diligence can generally be summarized as follows:
- For all – Reaffirms the details of the investment mandates to the investment manager’s teams, the necessity for adhering to them, and the investor’s desire to minimize operational risks.
- For managers with less sophisticated internal support – Creates an opportunity for strengthening internal systems, procedures, and safeguards that preserve the investment mandate and minimize operational risks.
- For managers who operate outside of their investment mandates in a transparent manner or have systems and processes that expose the investor to unnecessary risks – Creates an opportunity for constructive redirection of any internal systems, procedures, and personnel.
- For those who are covering up an overt disregard of their investment mandate or an overt disregard for systems and process to reduce risk – Creates a potential deterrent, as the process increases their risk of being discovered.
- For investors – Provides feedback that strengthens the understanding of operational risks associated with individual investment managers, and provides assurance of increased manager accountability for maintaining the investment mandate and reducing operational risks.
While it is impossible to eliminate all risks involved with any investment, a strong operational due diligence program can help mitigate such risks and provide investors with valuable insight to help them make investment decisions.
We would be pleased to provide further information related to this subject. For more information, contact Thomas A. Peters, Director, Audit & Accounting at tpeters@kmco.com.
You may also like: