The Hedge Fund Smell Test

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In “Hedge Fund Investing: The 4-Ps,” I discussed the notion of due diligence and how investors might go about selecting a hedge fund manager. In theory, the range of criteria that can be used to make such a assessment is unlimited, which means that it could be hard to make any decision at all.

Practically speaking, there are things to look and watch out for that can make it easier to narrow the field to a more manageable number. Although some might challenge this view, experience and logic suggest that the most important consideration when it comes to hedge fund investing (or, for that matter, any type of financial relationship) centers on people–that is, those who will be managing and otherwise looking after the assets. In the end, they have the future in their hand; if there are any doubts, that is reason alone to give it a pass.

How Does it “Smell”?

The best and easiest starting point for evaluating this aspect is the smell test. if something doesn’t “smell,” or seem, right, odds are that it isn’t. Needless to say, that probably sounds a little vague and suggests, rightly so, that there can be considerable subjectivity involved, Depending on background, experience, knowledge, culture and a variety of other variables, what some view as “troubling” others might see as quirkiness or a minor hurdle that can easily be overcome.

Regardless, it is probably easier to make the assessment with certain perspectives in mind. At the very least, working with a list of things to consider can help to avoid leaving important details out. Among the questions a prospective investor might want to consider are:

• Do both senior and junior-level fund employees come across as “honest” and forthright about their abilities and experience and what they can offer? Are they overly secretive about their investment philosophy, process and technical capabilities? Are they willing and able to discuss and acknowledge strengths and weaknesses? No matter how talented they are, there are going to be some areas where they come up short.
• Is there a disconnect between what they say and the message being conveyed by presentations, regulatory filings, and other aspects of their business? If they claim, for example, to have had a record of success, does this seem to be reflected in the way they operate? Do the facilities, marketing materials and other aspects of the business seem overly fancy or “slick,” especially in the case of a smaller, less well-known manager? That could reflect an attempt to cover up weaknesses in their approach–or worse.
• Do they understand that there is more to the investing process than performance alone? In other words, are they attuned to the importance of having an adequate operational infrastructure and an appropriate number and quality of staff necessary to ensure that things function as they should? Some hedge funds, for example, make it a habit of issuing Schedule K-1s many months after the April tax filing date, which can be an inconvenience for some investors.
• What about “the company they keep”? Have they engaged prime brokers, auditors, administrators and other service-providers? Are these firms unknown quantities or “one-man bands”? While there is no reason to be against working with smaller, presumably more nimble partners, many hedge fund frauds have been facilitated by no-name providers who acted in collusion with the bad apples or who weren’t concerned about reputational risk.
• Is the manager oriented towards institutional clients or focused on asset-raising rather than performance? As discussed in “The Misguided Focus on Hedge Fund Fees,” ambition is not necessarily a bad thing in any business, including money management, but if growth is the main emphasis, then the interests of smaller investors, in particular, probably won’t be best served.
• Finally, do employees “eat their own cooking?”–in other words, do they invest alongside their clients? While having skin in the game isn’t necessarily a requirement, especially in cases where fund managers are themselves seeking to diversify their investments, it is certainly a question worth asking. If they don’t seem confident enough in their product, perhaps prospective clients shouldn’t feel that way either?

Other considerations

That’s not the end of it, of course. There are plenty of other human elements that can and should be taken into account before investing. As a matter of fact, while it is generally frowned upon to consider factors such as gender or age when making decisions about business relationships, there is some data that suggests it may be relevant in this case. According to research compiled by KPMG, for example, “female hedge-fund managers have outperformed their male counterparts by a wide margin since 2007.” Other data indicates that small funds, which presumably have fewer elder statesmen in their ranks, have outperformed their larger peers, especially during crises.

Regardless, there are no guarantees that a hedge fund manager, however selected, will live up to even the lowest of expectations. But if questions about the individuals who will be looking after an investment can be answered satisfactorily, that likely goes some way towards ensuring that the decision won’t be a regrettable one.