## **Learning Outcomes**

This article explains how professional investors conduct rigorous manager selection due diligence and structure ongoing monitoring for external investment managers in a CFA Level 2 context. It sets out the objectives and sequencing of a formal due diligence process, from initial screening and document collection through investment, organizational, legal, compliance, and operational review. The article explains what documents to request, which qualitative and quantitative criteria to prioritize, and how to interpret track records, risk statistics, and attribution results in a manager-evaluation framework. It examines how to assess governance, ownership, and key-person risk, and how to identify red flags in internal controls, valuation, trade processing, and service-provider arrangements. The discussion also covers special due diligence considerations for hedge funds and other alternative managers, including leverage, liquidity, and conflicts of interest. Finally, the article details how to design risk-based ongoing monitoring, including mandate-compliance checks, performance and style-drift analysis, trigger events for escalation or manager replacement, and documentation expectations for an institutional oversight program.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand the practical steps in selecting and monitoring third-party investment managers, with a focus on the following syllabus points:

- Outlining the standard due diligence process for external manager selection
- Identifying key qualitative and quantitative review criteria
- Explaining evaluation of investment strategies, risk controls, and performance history
- Recognizing the roles of legal, compliance, and operational reviews
- Describing ongoing risk-based monitoring and reporting obligations for external managers
- Distinguishing monitoring processes for traditional versus alternative asset managers

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. List three key areas examined in the initial due diligence of an external investment manager.
2. Why is ongoing monitoring necessary after an investment manager is appointed?
3. What is typically included in a manager's operational due diligence?
4. Which circumstance should always trigger an immediate review of an external manager?

## **Introduction**

Rigorous evaluation and monitoring of external managers is essential for controlling risk and achieving investment objectives in a delegated, multi-manager environment. Due diligence identifies strengths and weaknesses in a manager's investment process, organization, risk controls, legal framework, and operational setup. Ongoing monitoring helps ensure alignment with the client's interests, flags emerging risks, and supports fulfilment of fiduciary responsibilities. This article explains industry-standard selection due diligence steps and outlines key principles for effective manager monitoring, equipping you for both exam and professional success.

## **The Manager Selection Due Diligence Process**

Selecting an external investment manager involves far more than reviewing historical returns. A structured, risk-focused process is necessary to minimise principal–agent risk and to ensure the suitability of the manager's approach, controls, and organizational infrastructure. This process is usually formalized as a due diligence checklist.

### Key Steps in Manager Due Diligence

1. **Initial Screening:** Identify candidate managers that meet minimum requirements for strategy, assets under management, legal setup, track record, and fees.
2. **Document Review:** Request and evaluate materials such as the manager's ADV (in the US), marketing decks, strategy descriptions, policies, and audited financials.
3. **Investment Process Assessment:** Analyze the manager's philosophy, security selection, portfolio construction, and risk management practices.
4. **Performance Evaluation:** Review objective, risk-adjusted, and benchmark-relative performance over multiple periods and market cycles, including consistency and style adherence.
5. **Organizational Review:** Assess the firm's ownership, governance, key personnel (hiring, turnover), team stability, incentives, and culture.
6. **Operational Due Diligence:** Investigate internal controls, compliance systems, disaster recovery/business continuity, trading systems, pricing/valuation methods, and segregation of duties.

> **Key Term: operational due diligence**
> The process of scrutinizing a manager's internal processes, controls, and infrastructure to assess non-investment risks, such as fraud or error.
>
> **Key Term: principal–agent risk**
> The risk that the interests of the delegated external manager (the agent) do not align with the interests of the asset owner (the principal).

1. **Legal and Compliance Review:** Verify fund legal structure, regulatory registrations, contractual documentation, side letters, terms, and compliance with policy, regulation, and best market practice.
2. **Risk Management Controls:** Examine how the manager measures and limits risk, manages liquidity, and ensures independent risk oversight.
3. **Reference Checks:** Obtain references from previous clients, service providers (administrators, custodians, auditors), and other stakeholders.
4. **On-site Visit:** Conduct an in-person meeting for additional questions, observations, and to verify real operations.

### Special Considerations for Alternative Managers

In private equity, hedge funds, real assets, or less liquid strategies, the due diligence process must place even heavier emphasis on transparency, independent valuation, sub-adviser monitoring, conflicts of interest, and fund structure.

## **Legal and Compliance Assessment**

The legal and compliance evaluation is essential for protecting client assets and ensuring adherence to statutory and regulatory obligations. This review typically covers:

- Fund domicile and legal structure (LLC, LP, trust, etc.)
- Key service provider agreements (administrator, custodian)
- Review of offering documents, compliance manual, policies for ethical conduct, code of ethics adherence

### **Worked Example 1.1**

A pension fund is considering allocating to a new hedge fund manager. The fund has a strong 5-year record but poor segregation of duties and no independent fund administrator.

> **Answer:**
> The lack of independent fund administration raises significant operational risk, including potential mispricing, fraud, or error. The due diligence team should require evidence of robust, segregated controls and may request remedial action or reject the manager.

## **Ongoing Manager Monitoring**

Appointing an external manager is not the end, but only the start of a fiduciary oversight relationship. Systematic monitoring is essential for risk management and continued suitability.

### Core Elements of Ongoing Monitoring

1. **Mandate Compliance:** Confirm that the manager is operating within agreed investment guidelines and portfolio risk parameters.
2. **Performance Analysis:** Evaluate risk-adjusted return, drawdowns, relative/absolute returns, and attribution. Look for style drift or performance anomalies.
3. **Organizational Changes:** Monitor turnover of key personnel, changes in ownership, restructuring, compliance incidents, or major strategy shifts.
4. **Operational Controls:** Periodically review audit reports and operational controls, especially after changes in IT systems, administrators, or custodians.
5. **Fee and Expense Monitoring:** Validate that fees and expenses are charged as agreed and are market competitive.

> **Key Term: style drift**
> A situation where a manager's actual investment style diverges from the stated mandate or benchmark, increasing risk and reducing suitability.
>
> **Key Term: performance attribution**
> Analysis that decomposes portfolio returns to determine sources of performance, such as asset allocation, security selection, and interaction effects.

### **Worked Example 1.2**

A multi-manager platform receives notice of the departure of a head portfolio manager at one of its key equity manager appointments.

> **Answer:**
> Key-person changes should immediately trigger a review, including direct discussion with the manager, reassessment of team depth, check for succession planning, and a decision if a formal manager replacement search is warranted.

### Monitoring Frequency and Escalation

- **Regular Reporting:** Quantitative and qualitative reports are typically required monthly or quarterly.
- **Red Flags:** Large negative returns, increased trade errors, regulatory fines, or operational incidents require prompt, detailed investigation.
- **Annual Review:** A comprehensive review may revisit full-scope due diligence, independent of ongoing monitoring.

### **Exam Warning**

> On the exam, failure to recognise that organizational changes or operational control breakdowns must prompt immediate review is a frequent error. Ongoing monitoring for style drift and mandate compliance is always required—do not rely on historical performance alone.

## **Summary**

External manager selection and monitoring require a diligent, ongoing assessment of investment process, risk controls, legal, and operational risk. Effective due diligence reduces principal–agent risks and protects client assets. Ongoing monitoring ensures the manager remains suitable and compliant as market and organizational conditions change.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Manager due diligence includes investment, legal, operational, and organizational review
- Evaluation of risk controls and compliance is essential for protecting client assets
- Ongoing monitoring is required for mandate compliance, performance, and operational changes
- Organizational or key-person changes must trigger immediate manager review
- Style drift, control breakdowns, or performance anomalies require escalation

## **Key Terms and Concepts**

- operational due diligence
- principal–agent risk
- style drift
- performance attribution


Performance evaluation and risk management - Manager selection due diligence and monitoring