Due diligence
Also written Manager due diligence · Portfolio manager due diligence
A client's own investigation of a portfolio manager before appointing them — checking process, people and past performance against a benchmark, not just the headline return.
In plain language
Picking a portfolio manager on last year's return alone is like hiring a driver because they arrived early once. It tells you too little. Due diligence is the wider check.
The XXI-A workbook describes it as "thorough quantitative and qualitative analysis of the portfolio manager's reputation, key personnel and operations". In short, it looks at the process behind the number, not just the number itself.
The workbook also gives a suggested order. First, decide what you need: an investment policy and an asset allocation. Only then go looking for the manager who best delivers it. Do not start from a manager's brochure and work backwards.
How it works
Chapter 10 lists what an investor's due diligence should weigh: investment philosophy, investment approach, investment process, strategies and styles, and past performance measured against a benchmark or a managers' universe rather than in isolation. It singles out one item as "of course... a crucial factor too" — management fees and costs.
The same chapter, a few pages earlier, gives a worked example of exactly the fee structure a due-diligence review has to price in: a hurdle rate of 10% of the amount invested, a fixed management fee of 1.5% charged on the average of capital contribution and portfolio value, and a performance fee of 20% of profits over the hurdle, without a catch-up — all figures the workbook itself flags as illustrative ("e.g."), but structurally exactly what a candidate manager's fee schedule looks like. Comparing that structure across two managers with similar gross returns is where due diligence earns its keep.
A worked example
Priya Shah, evaluating two portfolio managers for a Rs 2 crore mandate, is shown identical trailing three-year gross returns of 14% a year by both. A due-diligence check goes further.
Manager A charges a fixed fee of 2.5% of AUM with no performance fee. On a Rs 2 crore portfolio that is a flat Rs 5,00,000 a year, regardless of how the portfolio performs.
Manager B charges the workbook's illustrative structure: a 1.5% fixed fee plus 20% of profit over a 10% hurdle. On the same Rs 2 crore growing 14% in a year (to Rs 2.28 crore before fees):
Fixed fee = 1.5% × average of Rs 2 crore and Rs 2.28 crore ≈ 1.5% × Rs 2.14 crore = Rs 3,21,000 Profit over hurdle = 14% − 10% = 4% of Rs 2 crore = Rs 8,00,000; performance fee = 20% × Rs 8,00,000 = Rs 1,60,000 Total fee ≈ Rs 4,81,000
Manager B is marginally cheaper in this particular year, but only because the return happened to land close to the hurdle — in a year where the portfolio returns 22%, Manager B's performance fee alone jumps to Rs 3,44,000 (20% of the 12-point excess over the 10% hurdle on Rs 2 crore), pushing total fees well above Manager A's flat 2.5%. Due diligence means running both fee structures across a range of outcomes, not comparing them at one assumed return.
Why NISM asks about it
Chapter 10, section 10.7 (Due Diligence and Portfolio Manager Selection), closes the performance-measurement chapter by turning the measurement tools taught earlier in it — benchmarks, the managers' universe, net and gross return, fee structures — into a checklist for choosing a manager. A PMS distributor is expected to walk a client through exactly this checklist rather than recommend on trailing return alone.
Common exam traps
- Fees are named in the workbook as "of course... a crucial factor," not a minor one — a candidate who lists only philosophy and process without cost is answering half the section.
- Comparing gross returns without netting for the fee structure hides the real cost difference, especially when one manager charges a flat fee and another charges a hurdle-and-performance structure — the ranking can flip depending on the return assumed.
- Due diligence starts from the investor's own policy statement and asset allocation, not from a manager's marketing material — the workbook's stated sequence is policy first, manager second.
- Past performance is compared to a benchmark or managers' universe, not read in isolation. A 14% return means little without knowing what a comparable benchmark or peer group returned over the same period.
Where this is taught
Free preparation for NISM Series XIX-BRelated terms
- Sharpe ratioReturn earned above the risk-free rate divided by standard deviation — how much reward an investment produced for each unit of total risk its holder had to live with.
- Portfolio Management ServicesA tailored investment service where the client owns the securities directly in their own name, regulated under the SEBI (Portfolio Managers) Regulations, with a minimum investment of Rs 50 lakh.
- BenchmarkThe independently published index a scheme's performance is measured against, chosen to match its investment objective, asset allocation and strategy, and disclosed in the Scheme Information Document.
- Hurdle rateThe minimum return that must accrue to investors before the manager earns any incentive fee — the threshold that turns a fund's profit into the manager's profit.
- Right of First RefusalA shareholder right to match the best outside quote a selling shareholder has obtained — the holder sees the price first and may buy at it, or refuse and let the sale proceed.
- Non-binding Letter of IntentThe document a private equity fund gives a target after initial due diligence, proposing an investment amount, a valuation and a stake — none of which it is yet obliged to honour.
- Lead InvestorThe investor who sources a deal, does the diligence, commits their own capital and then assembles a syndicate of accredited investors to fund the rest — usually for a fee or a share of carry.
- Empanelled valuation agencyA valuation agency approved by APMI from whose panel every portfolio manager must mandatorily source debt and money market security prices, though the manager still bears ultimate responsibility for fair valuation.
- Performance feeThe variable fee a portfolio manager charges as a share of profit above a hurdle rate, on top of a fixed management fee: 20% of gains over the hurdle, without catch-up, in the workbook's own illustration.