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Home > Asset Management Best Practice > Carrying Out Due Diligence on Hedge Funds

Asset Management Best Practice

Carrying Out Due Diligence on Hedge Funds

by Amarendra Swarup

Executive Summary

  • Due diligence should be the cornerstone of any hedge fund investment program.

  • Hedge funds are a complex and volatile asset class, and poor selection will greatly increase the chances of fraud and poor performance.

  • Due diligence is about identifying the best hedge fund manager for your investment goals and risk appetite.

  • Due diligence is proactive risk management that seeks to generate superior returns while minimizing risk.

  • Performance alone is meaningless.

  • You need to understand how and why a hedge fund makes money.

  • Dig deep and understand all the risks in all possible markets.

  • If in the slightest doubt about a fund, just walk away.

Introduction

Hedge funds have often been cited as valuable additions to any institutional portfolio, thanks to their typically uncorrelated returns to traditional asset classes over the long term, and superior risk-adjusted returns. However, they are also a complex and volatile asset class, and since their ascent onto the investment podium, both institutional and private investors have found themselves burned at regular intervals by embarrassing and costly blowups. The oft-cited collapse of Long-Term Capital Management in 1998 and Amaranth Advisers in 2006, the litany of hedge fund managers wrong-footed by the credit crunch, and, most recently, the uncovering of the US$50 billion Ponzi scheme run by Bernie Madoff are but some of the stark reminders of the minefield investors navigate in their quest for absolute and consistent returns.

The reason is simple: Today’s increasingly complex asset markets make it more difficult than ever for investors to peer under the bonnet and select the best hedge funds. Many make the naïve decision to invest based solely on a strong track record, little realizing that the simple effort of conducting a thorough investigation into the fund prior to investment can often save them considerable financial pain in the future.

Due diligence is the most important aspect of investing in hedge funds, and often also the most ignored part. It’s a bizarre oversight—most people would not buy a house without learning first about the area, local schools, and amenities, conducting structural surveys, investigating the state of the housing market, and so on. Yet when most institutional investors allocate to hedge funds, the lack of simple questions as to honesty, competence, and future potential reduces most investments to the ignoble status of a crapshoot.

Due Diligence: A Definition

Due diligence is the process of identifying the best hedge fund manager for your investment goals and thereafter continually reevaluating them at regular intervals to ensure that they continue to meet your requirements. In doing so, it looks across the entire gamut of the fund—its investment strategy, performance, personnel, legal structure, risk management, documentation, operational infrastructure, service providers, counterparties, and client base. In essence, it is a proactive risk management approach that successfully balances the twin goals of any investment: generating superior returns while minimizing risk.

Looking at past performance alone is often meaningless in the hedge fund world. Performance tells you nothing about the underlying strategy, its advantages and disadvantages, management’s skill, the use of leverage, the impact of different market conditions, and so on. Further, selection bias means that most investors will naturally gravitate toward those strategies and funds that have performed well in the past. Any successful hedge fund strategy will seek in principle to deliver targeted returns within the confines of some defined risk constraints. Yet, while quantitative measures such as volatility capture the riskiness of performance, it does not tell investors how robust the fund’s underlying risk management is and how it may react to leaner times in the future.

In contrast, careful due diligence provides a valuable insight into the quality of the fund’s strategy, personnel, systems, and, vitally, their risk management. Investors know what to expect in good and bad times, and are able to approach their investment in a rational manner without worrying over every inevitable jitter.

The questions you ask are driven ultimately by your investment goals and the constraints on your balance sheet, such as your investment horizon and the need to maintain an optimal liquidity profile commensurate with your cash flow requirements. While no two investors are likely to have the same set of questions, there are fundamental areas that any proper due diligence process needs to cover.

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Further reading

Websites:

  • Alternative Investment Management Association (AIMA): www.aima.org
  • Chartered Alternative Investment Analyst (CAIA) Association: www.caia.org

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