Hedge fund due diligence is a complex and highly specialized process that is often delegated to hedge fund consultants. While you can let them do the hedge fund research, you should have a good understanding of the due diligence process and check up on them. After all, they may care about your money, but I’m sure that you care much more about your money than they do and at the end of the day you are responsible for your gains or losses.
The very first factor to consider when examining a hedge fund is how it relates to the bigger picture. Asset allocation is responsible for the vast majority of your returns, so if you are already over weight equities, there is little point in taking the time to research yet another equity fund, unless your existing equity fund manager is under performing.
Next you have to look at the investment strategy of the fund that you are considering. Many times you’ll see that a fund is really providing disguised beta as opposed to true alpha. They may be exposed to a hidden risk factor that is the true source of its returns as opposed to generating alpha from skillful trading. Are they highly concentrated in illiquid names and currently benefiting from the illiquidity premium in an era of excess liquidity? If they are, this could be a concern when liquidity dries up.
What Is the Edge?
Every firm should be able to explain their edge, or what it is that allows them to generate excess returns without taking more risk. Do they have an advanced HFT algo and co-location on the exchange floor that allows them to react faster than others? Do they have a stellar reputation that results in block traders coming to them first with their largest orders? Do they have a process that results in consistently good trades or do they rely on a single genius manager calling the shots? What is their edge and how likely will they be able to keep exploiting it is a very important question.
Proper Operating Structure
Ideally you would like to see segregated accounts at reputable custodians with full transparency. You want your investment kept separate from other people in case things go wrong. This way you retain full control over your money, while the hedge fund manager directs the trades in your own account. This also gives you good insight into what the manager is doing so that you can watch for style drift.
You also want the fund to have a highly trusted independent auditor. A small, no name auditor with no reputation is a big red flag. For all you know, this type of auditor could be the fund manager’s brother in law. You want an independent auditor with a national reputation to confirm that the hedge fund’s accounts are in order and that they money is where they say it is. Anything less and you better watch out.
Trust your gut instinct. A fund may pass all of the tests, but something may not feel right. Don’t ignore this feeling. Fraudsters will often do everything in their power to make sure they look like a firm with the highest credibility. They know exactly how to say all of the right things and make sure that all of the boxes are checked, but sometimes your intuition can be your best guide.