Last Updated: November 17, 2015

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There are various reasons why someone might want to invest in a hedge fund. The most obvious, of course, is performance, or more accurately, the prospect of acceptable future performance, however that is defined. There is no point in entrusting funds to a manager if such a possibility doesn’t exist, or if it seems unlikely. Generally speaking, someone who claims to have investment acumen should be capable of producing returns, after fees and expenses, that are “better” in one way or another than what one might hope to realize, say, by investing in an index fund or with a traditional “long-only” manager.

Other rationales might include the desire for increased diversification or lower portfolio volatility than can be achieved through “plain vanilla” investing. Again, while past performance is no guarantee of future results, there should be some basis for believing that a manager can achieve such goals. Whether it reflects a manager’s past track record or experience (e.g., at an investment bank), or the fact that the strategy in question seems to have a lot going for it based on backtesting, logic, economic rational or other factors, the manager’s approach needs to be seen as being up to the task.

Another reason why investors might want to invest in a hedge fund is to establish a better balance between investments geared towards increasing or preserving capital, especially in an environment–like now, perhaps–when stock and bond valuations are rich in relative terms and the risk seems high that their prices will fall. In theory, a manager who can buy or sell-short, or who can invest in instruments that can “zig” when traditional asset prices “zag,” should be able to perform well regardless of how the latter are faring.

The next step

Needless to say, once a decision is made, the next step is figuring out which manager fits the bill. Although there are many ways of addressing this question, they generally all fall under the heading of “due diligence.” There’s no doubt that this topic has been covered quite a bit, in articles like “Performing Due Diligence in Manager Selection” and “Red Flags to be Aware of in Manager Selection,” as well as in academic research and a variety of trade books and textbooks. Nevertheless, the desire to eliminate or reduce the risk of making a bad decision suggests that more is better when it comes to due diligence.

Unfortunately, the process is often described in terms that include heavy dollops of academic language and jargon, which can make it hard to understand what the goals are and which aspects are most important. In reality, the point of the exercise is pretty straightforward: to determine 1) whether or not a fund is a fraud, and 2) if a manager is capable of doing what is claimed. In some cases, the answers may be clear after reading through documents and engaging in an in-depth discussion with the investment team. More often than not, it requires a “deep dive” into various aspects of the business, including the operational structure and service providers.

Philosophy, Process, Performance and People

Philosophy, process, performance and people

Arguably, there is no right or a wrong way to conduct due diligence. Certain investors, especially institutions, believe that the more hard data they have, the better; others, including some individuals and family offices, which invest on behalf of wealthy clients, may rely more on what their instincts tell them than on metrics and documents. Whatever the approach, the process typically focuses on four areas: philosophy, process, performance and people. Many prospective investors believe that if they have a solid grasp of the “4-Ps,” they can make a decision that, at the very least, allows them to sleep at night.

For the most part, “philosophy” details the reason why the fund exists: what are its guiding principles and, more importantly, how does it generate returns. Although it might sound like a simple enough question, it’s one that requires a clear answer, because it can help determine whether the approach is rational and well thought out. It can also help an investor understand whether the firm is capitalizing on its strengths, rather than simply trying to “make money,” and to have a good handle on the risks being taken. There’s nothing wrong with “making money” per se, but a cynic might say it was probably the same answer that Bernie Madoff gave his investors while he perpetrated what turned out to be one of the world’s largest frauds.

The notion of “process” seems somewhat self-evident, but an overview from Nevada-based registered investment advisor Bidart & Ross on evaluating this aspect of an investment manager’s modus operandi seems to cover the bases:

Focus on how managers put their investment philosophy into practice. Obtain sufficiently detailed descriptions of portfolio construction methodologies, screening processes, and buy and sell discipline, and address any apparent contradictions or perceived inconsistencies. Further, discover whether individuals or teams manage the portfolio, if leverage or derivatives are used, and how risk is managed. Finally, evaluate whether the stated and observed practices are in line with the desired objective.

The next focus of the due diligence process would also seem to leave little room for doubt, but that is not necessarily the case; it is important to view performance in a proper context. In the hedge fund space, in particular, and in the investment world, more generally, it is not just returns that matter; typically, investments are evaluated from the perspective of both risk and reward. If a manager outpaced, say, the S&P 500 over some period of time but experienced much wider monthly performance swings or larger peak-to-trough declines in capital than an index investor did, that might be viewed as disappointing. Similarly, if a manager gained 4% while traditional markets crashed, it might be seen as a stellar success. Either way, the goal is to understand what happened in the past, and figure out if it might be repeated in future.

The fourth spoke

When it comes to “people,” the notion of “last, but not least,” certainly applies. In fact, while some might believe that all four factors carry equal weight, the reality is that it is individuals who determine and influence the other three variables. With that in mind, this fourth spoke of the due diligence wheel is covered in greater detail in “The Hedge Fund Smell Test.”

Michael Panzner

Michael J. Panzner is a 30-year Wall Street veteran and the author of three books, including Financial Armageddon, which predicted the 2008 global financial crisis.