Markets in a Minute: Why Your Due Diligence Playbook Matters

From the PM Desk: Why Your Due Diligence Playbook Matters

“The only place that success comes before work is in the dictionary.” 

~ Vince Lombardi 

Consider that building a successful portfolio is a lot like putting together a winning football team. Whether you’re an investor or an NFL scout, it’s important to do your homework (or due diligence) to select the right holdings or players, not necessarily just the star performers. If done well, the proverbial whole should be greater than the sum of its parts.  

In this edition of Markets in a Minute, we take a high-level look at our due diligence process, the football equivalent of all the work that takes place before the season even begins. We focus on what to consider when building a portfolio using exchange traded funds (ETFs), which today attract the majority of fund flows. Yet many of the same considerations apply to mutual funds and individual securities. And since it’s the start of football season, we’ve thrown in a few more football analogies for good measure.  

Quantitative Screening 

In broad terms, quantitative screening is what we do to identify promising funds by weeding out candidates that don’t measure up on key metrics. We look at fund performance over the long term – to distinguish skill from luck – but that’s just a starting point. We also evaluate expense ratios, assets under management, whether funds have remained true to their stated investment style, downside risk, and much more.  

In many regards, quantitative screening is a lot like the annual NFL Combine, an invitation-only event during which scouts evaluate draft-eligible college players based on their performance on mental and physical tests, including the 40-yard dash, bench press and vertical jump.  

Scouts pay particular attention to how individual players perform on position-specific skills, which only makes sense. After all, the qualities needed for a great offensive lineman (size and strength, for instance) are different than those needed for a top-notch quarterback (like leadership, speed and passing accuracy).  

The same logic applies to quantitative screening. Each fund has a specific role to play in a diversified portfolio, so we look at different types of funds through different lenses. The role of real estate or utilities funds, for instance, is downside protection and income generation. So, we place more importance on yields than, say, share-price appreciation.  

Qualitative Screening 

Just as Combine performance may not be enough for a player to make it into the NFL, quantitative screening is only one piece of the puzzle when evaluating ETFs. We also get to know the asset-management firms in charge of the funds we’re considering through direct interviews and other independent research. What are we looking for? Some of the factors that matter most are organization history, management-team experience, investment process and resource allocation. Firms with high management turnover, insufficient assets or scant exposure to a given asset class or sector don’t make the cut.  

Portfolio Construction

Keep in mind that selecting the “best” ETFs isn’t about cherry picking funds based on their individual performance metrics and manager quality. Investors should also consider the bigger picture – or how each fund fits into a broader portfolio strategy. Our playbook calls for:  

Building a cohesive investment puzzle: Select ETFs that align with investment goals, risk tolerance and time horizon, ensuring that each portfolio holding contributes to intended diversification and avoids concentration risk. Too much exposure to specific companies, asset classes or market segments can amplify losses.  

Balancing risk and return: Different ETFs can help balance portfolio risk. For instance, mixing growth– and value-oriented funds, or stock and bond funds, can lower portfolio volatility and enhance returns.  

Ensuring strategic fit and alignment with investment objectives: Each ETF should match specific investment objectives, such as income generation, capital appreciation or hedging against inflation.  

Run the plays against the practice squad: Regularly perform stress tests and scenario analyses to assess how a portfolio is likely to respond to changing market conditions, and continuously monitor and rebalance to stay aligned with original asset-allocation strategy.

The End Zone 

In many ways, building a successful portfolio is easier than ever. The number of ETFs and mutual funds has skyrocketed in recent years to roughly 10,400 (not counting multiple share classes). Investors have many more tools to gain exposure to all corners of the markets, and competition has driven down fund costs too.

At the same time, the proliferation of ETFs has added complexity to the fund-selection process, making thoughtful due diligence very important. Over the long term, a disciplined approach to fund selection should help investors get to the end zone, whether that’s a comfortable retirement, paying for college or another financial goal. 

Invest wisely and live richly,  

The PM Team