Investment objectives vary among investors, but generally include return expectations, risk tolerance, liquidity needs, asset mixes, investment time horizons, leverage limits, currency choices, and tax considerations. A clear understanding of investment objectives and constraints helps to quickly narrow down the pool of funds to consider.

Investors can obtain information of funds and fund managers through SEC’s IAPD site, industry conferences, prime brokers, subscription-based databases, fund and manager websites, and google searches, among others. 

There are many thousands of hedge funds, and materials you need to process can be overwhelming.  Hence, it is critical that investors are clear about their investment objectives and constraints to quickly narrow down the pool of funds to consider.  With a smaller group of prospects, investors can then effectively research individual funds.

The purpose of hedge fund research is to find funds that can consistently deliver future absolute and risk-adjusted returns superior to their peers and benchmarks.

An average hedge fund outperforms its benchmark on a risk-adjusted basis but underperforms in absolute returns, as we have shown in Type of Hedge Funds. While superior risk-adjusted returns are valuable, investors desire high absolute returns as well. 

Fortunately, there are huge performance dispersions among hedge funds. In each strategy and asset category, there are usually a handful of funds that outperform benchmarks on both absolute and risk-adjusted returns. It is highly beneficial to research and identify these winners.  Furthermore, hedge funds are complex operations. A thorough research and due diligence also mitigate risks and prevent fraud. 

Areas where established institutions would examine include:

• Asset Class and Strategy: Understand the nature, breadth, liquidity, drivers, instruments, price patterns through market cycles, et al, of the asset class.  Study the nature, capacity, leverage, concentration, source of alpha, beta exposure, major players, risks, and performance through market cycles, et al, of the investment strategies.  Ensure asset and strategy selection is consistent with your investment goals and risk tolerance. Check the size of the fund and its available capacity for new investors.

• Investment Process: Evaluate the research, idea generation, investment decision, portfolio construction, and risk management process and practice. Ensure that a fund manager can operate smoothly under stress and safeguard investor assets through financial crises.

• Risk Management: Review portfolio leverage, concentration, position size, use of derivatives, and other risk parameters. Understand risk monitoring, review, management systems, and processes.  Understand how a fund manages a winner and deals with a loser. Ensure a proper balance in a fund’s positioning and mindset to ride a favorable trend and withstand a market dislocation.

• Team and Continuity: Check the background, experience, and past achievements of portfolio managers and analysts; and key client, risk, compliance, and operating staff.  Review employee ownership, incentive schemes, work environment, staff turnover record, et al. Assess if the organization has a strong leader and is a pleasant place to work, and whether it will be able to retain and attract talent to replicate past investment returns.

• Operation and Compliance: A fund delegated its operation to its investment manager and service providers. An investment manager is responsible for conducting research and investment, managing risks, providing investor service, maintaining internal control, ensuring regulatory compliance, keeping accounts and books independently of service providers, coordinating service providers, and conducting annual audits and tax filings.  Ensure a manager is properly staffed with expertise in legal, accounting, compliance, and other critical areas.  Verify proper internal control and coordination with external advisors to ensure ethical and regulatory compliance. Check there are no past legal and regulatory issues. Check the necessary systems, infrastructure, and processes that support a smooth operation.

• Performance: Check the length of track records and if a fund has weathered market cycles.  Evaluate historical returns, exposures, alpha and beta components, and correlations with the benchmarks. Check various metrics such as Sharpe ratio, % win/loss, maximum drawdown, et al. Past performance doesn’t guarantee future results, but it can provide insight into how well the manager adapts to changing market dynamics. Verify if quantitative metrics align with your qualitative assessment.

• Edge: Consolidate and distill all analyses relating to investing. Assess if a fund manager has an edge and understand the source of such an edge. What exactly enables a manager to outperform?  Can the manager sustain its edge into the future?

• Structure and Governance: Review fund entities and management company structure and ownership, offering memorandum and other documents.  Check if a fund can accept on-shore (taxable) and off-shore (tax-exempt) investors.  Understand the composition of the board and the role, responsibility, frequency, and format of its oversight meetings. Dodd-Frank held the Directors of a fund liable for negligence and misrepresentation. Make sure you ask a fund for access to its directors.  Check if anything is unusual or presents a conflict of interest.  Ensure a fund has proper checks and balances.

• Service Providers: Service providers are vital in safekeeping investor assets and ensuring the independence and integrity of the reported investment returns.  The reputation of service providers is often a good reflection of a fund’s quality. Dodd-Frank held service providers of a fund liable for negligence and misrepresentation. Make sure you ask a fund for access to its service providers.

• Transparency: Understand how fund managers communicate with investors, provide performance updates, and disclose portfolio holdings and risk exposures.  Ensure that a fund provides all necessary documents, makes principals and board members available, and allows independent checking with its service providers. At the same time, respect a manager’s duty to protect proprietary knowledge, information, or skill associated with its ability to deliver superior returns.

• Terms: Understand the fund’s management and incentive fees, other costs of operating the funds, hurdle rate, high watermark, minimum investment, subscription and redemption frequency, lock-up period, and other terms.  Check PPM (Private Placement Memorandum) or other offering documents for other important terms, conditions, and disclosures.

Hedge fund research is a labor-intensive process. This list does not intend to be exhaustive, but a manager may not grant individual investors full access to info and people as it does for institutions.  Also, while many tend to focus on returns and other quantitative metrics, it is our experience that qualitative assessments are vital in providing insight into how a fund manager tends to perform in the future.

Collecting data, conducting research, and carrying out hedge fund due diligence are intertwined, and hedge fund selection is an iterative process.  Although specifics may vary from one institutional investor to the other, major due diligence tasks include:

• Authenticate: Verify legal documents, performance data, risk parameters, key staff background and experience through regulatory filings, administrative reports, audited financial statements, interviews, et al.

• Background Check: Conduct background checks of the fund, the management company, and their senior staff in the front and back offices.

• Service Provider Interview: Interview custodian banks, prime brokers, law firms, and especially administrators and accounting firms. Talk to independent directors of the fund.  You will need the fund manager’s consent to formally check references and conduct interviews.  Do it formally as well as informally chat with people to independently verify important facts and data.

• Site Visit: Visit the fund and its manager at their main office. Meet and interview principals and key front and back-office staff.  Double-check all key areas of the hedge fund research and due diligence list.

Institutions often have both formal and informal processes to allocate their investment capital.

Informally an analyst approaches an authorized principal of a firm about a small initial allocation to a fund.  The analyst presents the research and due diligence findings and makes an investment case.  If convinced, the principal allocates an amount at his discretion, within the limit of his/her authorization.

In a formal process, a senior staff coordinates the preparation of the investment proposals.  These proposals typically include investment summaries making cases for allocations, backed by the research and due diligence findings, macro/market environment and asset/investment strategy outlooks, and current and post allocation portfolio compositions and risk exposures, et al.

Investment committee member review these proposals before they meet.  During the meeting, a chairperson facilitates and presentations, Q&A, and often spirited debates before casting votes.  Most firms require a unanimous yes vote to invest in a candidate.