![88 | financial advisor magazine | november 2013 www.fa-mag.com
Hedge Fund Due Diligence: 20 Key Issues And The Sources That Provide Answers
figure 1
primary issues
portfolio
management
key points document sources
Portfolio Composition
Strategy Consistency
AUM And Leverage
Performance, Volatility And Fees
Hedging Strategy
Manager Background, Tenure
And Size Of Team
Management’s Financial
Exposure To The Fund
Conflicts Of Interest
Past Malfeasance/Bankruptcy
Service Providers
Look at concentration and diversification by position,
sector and asset class to determine exposure and
potential volatility and risk.
One needs to be able to understand a fund’s strategy
and its execution, along with the potential for investment
deviation and style drift.
Identify the size of the fund, and the degree, stability of
source, cost and duration of leverage to help distinguish
AUM from notional [regulatory] value.
Monitor quality and consistency of returns through
analysis of monthly performance, confirming relevancy of
benchmark and then assessing consistency and source of
outperformance; determine worst drawdown and duration
of recovery; identify and understand how management
and performance fees affect returns; and distinguish be-
tween early performance that may have been boosted by
low initial fees versus performance net of current fees.
A key indicator of whether downside risk is capped is
when primary positions are hedged through exposure
to opposing positions; substantial reliance on unhedged
single-directional trades may generate greater upside but
comes with more potential volatility and risk.
Presentation, Prime Brokerage
Statement
Presentation, DDQ, PPM, Prime
Brokerage Statements, Audited
Financials
DDQ, PPM, Audited Financials
Presentation, Monthly Report
Presentation, DDQ, Prime
Brokerage Statement
Presentation, DDQ, ADV,
SEC—IAPD
Audited Financials, DDQ
DDQ, ADV
ADV, SEC—IAPD
Presentation, Monthly
Report, DDQ
Learn a bit about the manager, distinguishing between
manager versus fund performance, and know how many
key people are around to run the fund.
Management and investor interests should be aligned.
Watch for trading through an affiliated broker-dealer; no
independent directors; investments in positions owned
by management; manager’s time divided across
other businesses.
Background checks are essential to know if key
managers have gotten into trouble and if they are telling
the truth about myriad things.
Suggests quality of operational execution and oversight
about myriad things.](https://image.slidesharecdn.com/fanoshortcutsfontsofflastpage-180108014113/85/Financial-Advisor-Magazine-No-Short-Cuts-2-320.jpg)
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- 1. 86 | financial advisor magazine | november 2013 www.fa-mag.com B ecause their operations are private and top man- agers enjoy celebrity-like status, hedge funds retain mysterious appeal to inves- tors looking for an edge. Why? Traditional money managers and mu- tual funds are largely index-centric with little chance of delivering substantial out- performance, while hedge fund managers are perceived as Peter Lynch unleashed. That’s simply not true. Relative to the market,most hedge funds have not been good investments.According to BarclayHedge, a major industry tracker, the average hedge fund has underperformed the SP 500 six out of the last 10 years,in- cluding the past four calendar years. Through the first half of this year, every hedge fund strategy substantially trailed the market, which was up nearly 14% through June. Even long equity bias funds underperformed the index by about 5%. Throw in persistent reports of malfea- sance, most recently headlined by long- time master of the universe Steve Cohen having his fund charged with insider trading, and most advisors may decide the waters are just too shark-infested to dive in. However, the biggest problem af- flicting the industry is that there are sim- ply too many managers, more than 8,000 at last count. Collectively, they have mired the value and perception of this independent form of asset management. Potential Value The case for hedge funds is that they can provide unique access to compelling, actively managed investment strategies such as distressed, event-driven, arbi- trage, global macro and long-short debt and equity. And yes, there are seasoned managers who have shown they can con- sistently deliver gains without taking you on a roller coaster ride or needing to hide from the Justice Department. For advisors who want to gain such ex- posure, the trick then is knowing how to Wealth Management /Investing Hedge funds can bring compelling exposure to a portfolio, but carefully vet the manager and the fund. Here’s a checklist. By Eric Uhlfelder No Short Cuts
- 2. 88 | financial advisor magazine | november 2013 www.fa-mag.com Hedge Fund Due Diligence: 20 Key Issues And The Sources That Provide Answers figure 1 primary issues portfolio management key points document sources Portfolio Composition Strategy Consistency AUM And Leverage Performance, Volatility And Fees Hedging Strategy Manager Background, Tenure And Size Of Team Management’s Financial Exposure To The Fund Conflicts Of Interest Past Malfeasance/Bankruptcy Service Providers Look at concentration and diversification by position, sector and asset class to determine exposure and potential volatility and risk. One needs to be able to understand a fund’s strategy and its execution, along with the potential for investment deviation and style drift. Identify the size of the fund, and the degree, stability of source, cost and duration of leverage to help distinguish AUM from notional [regulatory] value. Monitor quality and consistency of returns through analysis of monthly performance, confirming relevancy of benchmark and then assessing consistency and source of outperformance; determine worst drawdown and duration of recovery; identify and understand how management and performance fees affect returns; and distinguish be- tween early performance that may have been boosted by low initial fees versus performance net of current fees. A key indicator of whether downside risk is capped is when primary positions are hedged through exposure to opposing positions; substantial reliance on unhedged single-directional trades may generate greater upside but comes with more potential volatility and risk. Presentation, Prime Brokerage Statement Presentation, DDQ, PPM, Prime Brokerage Statements, Audited Financials DDQ, PPM, Audited Financials Presentation, Monthly Report Presentation, DDQ, Prime Brokerage Statement Presentation, DDQ, ADV, SEC—IAPD Audited Financials, DDQ DDQ, ADV ADV, SEC—IAPD Presentation, Monthly Report, DDQ Learn a bit about the manager, distinguishing between manager versus fund performance, and know how many key people are around to run the fund. Management and investor interests should be aligned. Watch for trading through an affiliated broker-dealer; no independent directors; investments in positions owned by management; manager’s time divided across other businesses. Background checks are essential to know if key managers have gotten into trouble and if they are telling the truth about myriad things. Suggests quality of operational execution and oversight about myriad things.
- 3. Hedge Fund Due Diligence: 20 Key Issues And The Sources That Provide Answers primary issues risk control transparency key points document sources Investment Oversight Valuation Of Assets Operational Risk Strategy Risk Limiting Losses Quality Of Fund Documents Current Investment Positions Investor Base Restrictions On Investor Redemption Investor Liquidity How are decisions made—individually or via consensus? Essential in assessing integrity of performance and liquidity. These include risks associated with counterparties, trade oversight and custody. Assess limitations and vulnerabilities of individual strategies. Understand how a fund may limit losses on individual positions and/or at the portfolio level. Presentation, DDQ DDQ, PPM DDQ Presentation, DDQ Presentation, DDQ Presentation, DDQ, ADV, SEC—IAPD Monthly Report, Prime Brokerage Statement, Recent Presentation, Recent Audited Financials DDQ, ADV PPM, DDQ Presentation, DDQ, PPM Key to assessing a fund’s transparency, its ability to communicate and management’s understanding of its own operations. Identify recent changes and why they have been made. Review number, types and geographical distribution of investors and ownership stake of significant investors. Gates, suspension and sidepockets are means in which a fund can hold onto capital when an investor requests redemption. Consider liquidity of investments versus terms of redemptions—how well the two are matched is a key to assessing redemption risk. november 2013 | financial advisor magazine | 89 first vet the hedge fund universe and then individual funds and managers to reduce the chance of getting clipped by a nega- tive surprise and to increase the odds of boosting client returns. Figure 1 will help you get started. It’s a primer of essential operational and in- vestment issues you need to understand before committing a penny to a fund. This review looks at four key categories: portfolio, management, risk control and transparency. The figure then identifies the underlying points each issue raises and the specific documents prepared by hedge funds that provide the answers. If they don’t, then avoid the fund. It’s that simple. Start the search process by considering funds with at least $100 million in assets. Make sure this is investor assets or net as- set value,not notional value,which includes leverage that could bump up the valuation several times. (Leverage exaggerates vola- tility. Advisors new to hedge funds should limit this multiple to three times NAV.) According to Jonathan Kanterman, a hedge fund consultant,when a fund’s NAV is at least $100 million, it likely ensures use of quality service providers, hiring of dedi- cated risk managers and chief financial of- ficers,and near-term sustainability. Kent Clark, who oversees $20 billion as chief investment officer of hedge fund strategies at Goldman Sachs Asset Man- agement, searches for compelling invest- ment theses when considering strategies and sectors. “We had raised cash during Wealth Management /Investing
- 4. the crisis,” recalls Clark, “and re-risked the portfolio post-crisis into, among oth- er things, credit. Since then, we’ve moved away from directional credit into more trading and long-short credit strategies.” To find the right managers, Clark re- views a very extensive list of character- istics, including “the investment team’s experience and expertise, alignment of investor and manager interests,thoughtful portfolio management, independent risk management with genuine input in the investment process, and clear evidence of qualified people, processes and systems.” Red Flags Knowing key red flags saves time, be- cause when they are seen,it puts an imme- diate end to a fund review. Listed in Fig- ure 3 are 10 such markers, ranging from management reluctance to clearly describe what they are doing,annual financials that are not audited and the inability to speak to one or two current investors. One important red flag not mentioned is maximum drawdown: the percentage that a fund has fallen from a peak before fully recovering anytime in its history. There is no one standard level of draw- down because it can vary significantly by strategy and the age of the fund. But for conservative advisors,that limit should be no more than 25%, and recovery should not exceed six to nine months. In addition, very small worst draw- downs are suspect, especially during times when you know the entire market has been slammed. If a number appears too good to be true, it probably is, reflecting suspect valuations or other financial engineering. Many funds collapsed through this figure in 2008 because of illiquidity and forced selling (not necessarily loss of qual- ity), which sent certain asset valuations plummeting. Some investors didn’t nec- essarily blame managers because of the universal meltdown going on at the time. And many who stayed on were rewarded as prices surged the following year. Others, however, were not as fortunate when they saw their funds shut down. All funds will tell you they actively manage risk and will discuss metrics like VaR (value at risk) and speak about decisive daily man- agement meetings to control the downside. If wealth preservation is your main concern, then it’s advisable to find man- agers who—at a certain point—have shown to be willing to throttle back ex- posure and/or leverage to stop the bleed- Documents figure 2 primary issues key points Presentation Monthly Report Form ADV Due Diligence Questionnaire (DDQ) Audited Financial Statements Private Placement Memorandum (PPM) SEC.gov/Independent Advisor Public Disclosure (IAPD) Prime Brokerage Statement Overview of the fund: history, strategy, performance, key management personnel, service providers and basic portfolio metrics. Performance note providing insight on what happened to the fund and related marketplace during the most recent reporting period; also may include service providers and key portfolio metrics. Required filing for all hedge fund managers with at least $150 million in assets; includes descriptions of firm, manager, fund, assets, investor composition, managers’ background, along with important disclosures and identification of any related businesses that might be owned by the fund’s principals. Explains a fund’s structure, strategy, risk controls, managers and operations. Reveals matters of performance, valuation, expenses and taxes. In essence a prospectus—a legal testament defining the structure, intent and limitations of the fund, making it the most important document that the manager disseminates; includes financial statements, management biographies and detailed description of the fund. Myriad regulatory information about fund and management, including past and pending disciplinary actions and Form ADV. Portfolio holdings, prices, number of shares and total value of each position— managers may not readily wish to share with prospective investors. 90 | financial advisor magazine | november 2013 www.fa-mag.com
- 5. ing. And those who claim they can do this will be able to explain the specific process and examples thereof. In a recent study of 22 hedge fund fail- ures, prepared by the nonprofit research and educational organization Greenwich Roundtable, the three most frequent causes (evident in half the cases) were excess leverage, liquidity problems and inadequate risk management. About a third of the time, key problems also in- volved inadequate transparency, unrea- sonable volatility and service providers. One of the easiest ways to help avoid problematic funds is to visit management before investing. During such trips, Jona- than Kanterman has discovered gaps be- tween what he reads in fund documents and what he sees involving staffing,technol- ogy, investment process and management spending time running other businesses.An on-site visit reveals something else that can’t be known from afar:If you aren’t treated like Warren Buffett,don’t invest. Coda Due diligence doesn’t stop once the in- vestment is made. It’s only the beginning. Every year you should review key issues and remain satisfied with the answers. Flag deviations,and if they aren’t resolved, then seriously question your investment. Goldman Sachs’ Clark says that when he sees “volatility larger than expected, it may suggest the manager is taking on more or different risk than we were told he would.And when we observe lower risk than expected,that may indicate inclusion of illiquidity and unmarked securities, or a manager deciding to focus on collecting management fees rather than trying to generate returns from performance fees.” For Clark, investors should never feel complacent. He believes “over the medium to long term, we don’t expect managers to consistently deliver strong returns and that fund rotation is an important part of achiev- ing consistent long-term performance.” Advisors can pass off due diligence by investing through institutional hedge fund platforms or funds of funds, with both ap- proaches bringing added fiduciary protec- tion.But this process will add another level of expense that may lead one to question whether the endeavor is worth it in the first place, because regardless of what industry pundits may say,hedge funds are not an es- sential part of any high-net-worth or insti- tutional portfolio.Good managers are.And until you find one,don’t invest. 10 Key Red Flags figure 3 primary issues key points Management’s Reluctance To Speak To Investors Unknown Service Providers Unaudited Financials Material Conflicts Of Interest Unclear And Incomplete Investor Communications Lack Of Access To Existing Investors For Reference Long-Term High Volatility Frequent Turnover Of Key Personnel Lack Of Manager Assets In The Fund Liquidity Mismatch Between Redemption Terms And Assets Potential for fiduciary failure. Potential for obscuring transparency and negatively impacting operational integrity and performance. Uncertainty about key financial metrics. Raises issues of integrity. Selective response to questions may suggest operational and investment deficiencies, potentially involving portfolio holdings, and a gap between manager vision and reality. Less than a compelling endorsement of the fund. Suggests an inability to control risk and issues with overall investment approach. Problems with the fund structure and internal relationships. Failure to link manager and investor interests. Investors may not be able to redeem shares as per agreement, especially during a financial crisis. november 2013 | financial advisor magazine | 91 Wealth Management /Investing NOTE: Jonathan Kanterman significantly contributed to the development of these figures.