This is the first of a three part series on due diligence of alternative investment managers. Since 2000 I’ve seen more institutional investors such as pension funds, endowments, foundations and family offices increasingly allocate to hedge funds and managed futures. The points listed below are important topics for CIO’s, board members and trustees of institutional investors.

As my background is research, this article discusses the research side of the due diligence process.

Over the years I’ve found investors perform varying degrees of due diligence of hedge funds. Some may only crunch the returns of the manager. Others will only ask the manager to fill out a due diligence questionnaire and some will do a full due diligence process on the manager including strategy, research and operational due diligence. Crunching the numbers and a due diligence questionnaire are good places to start, but is not the ending point as your goal is to get as close to a full due diligence process as possible. Ideally the investor does not want to be surprised once they invest.

Regarding the research/strategy component of due diligence, below are five major components to keep in mind when performing due diligence on a manager:

1) Know and understand as much as possible about the manager’s strategy:
Quite often I hear investors mention they were intimidated by the so-called “black box” and the managers would not tell them very much. There was a time in the past when managers were cautious of explaining the details of their system due to replication risk, but not today. Today many managers realize it is in their best interest to be as transparent as possible.

2) Major topics to discuss during due diligence:

• Are markets ever added or deleted from the portfolio? If so, why?
• What are the duration of winning trades and losing trades?
• What is their risk management? Do they use stops or profit targets? Do they leg into positions or enter the entire position at once? Do they keep the stops close or far away from the market? Do they spread or utilize options for risk management?-What is the average leverage range utilized in the portfolio?
• What could I expect as the maximum leverage range?
• What triggers a signal into a position and why?
• Is risk management used often or infrequently?
• Will the position size vary from trade to trade or will it remain static?
• How often is the system reviewed and modified?
• What type of market environment will the system work well and work poorly?
• Is there an overlay system within the portfolio? This idea does not often get much discussion. If there is an overlay, how much allocation does it get?

These may seem basic questions, but sometimes the most basic is missed. Each of these questions opens up the door to more complex conversations. Ideally you are trying to understand the concepts and defining a profile of the manager and allowing for a more realistic expectation of the manager.

3) Understand the research process:
The research process, a component that is often missed as investors talk about understanding the strategy, but less frequently does someone say they took time to understand the research process. Understanding how the manager develops and tests their research ideas and strategies may be the gateway to understanding the mindset of the manager.

• How much data was tested; one year or 30 years of data? -Was the portfolio tested on out of sample data?
• Was the portfolio tested for curve fitting?
• How does the manager test their ideas?

4) Onsite visit:
You should do an onsite visit to meet the research team.

• What are their functions and who leads the team and makes the research/ portfolio decisions?
• Is there anyone outside the team involved in research/ portfolio decisions?
• What is their disaster recovery plan for their research and portfolio teams?

5) Hire a qualified due diligence team:
For these listed components to occur properly, you have to hire a due diligence staff that understands the products and the research process. Due diligence is an extremely important process of the hedge fund industry. It should not be taken lightly. If the person or team doing the due diligence is well versed on the research, then the due diligence can be very enlightening.

Copyright ©2013, ©2015 Mark Shore