Hedge Funds

Hedge Fund Manager Selection and Due Diligence

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Hedge Fund Manager Selection is a crucial part of the investment process, requiring skill and knowledge. For those with responsibility for oversight of a multi-asset fund, the decision to make an allocation to hedge funds is relatively straightforward. Selecting the right hedge fund strategies and the right manager is far more difficult.

Selection of Hedge Fund Strategies

The selection of hedge fund style or strategy should normally come first, and will depend upon your existing portfolio and objectives. Here there are two main considerations; your return expectations, and the impact on your overall risk and diversification objectives.

As recent research from Lyxor shows (1), different hedge fund strategies tend to have different risk factor exposures, which may or may not suit your overall objectives. Some strategies will suit your purposes as a substitute for part of your equity allocation. Others may work well as a substitute for part of your fixed income allocation.

In terms of return expectations, you may wish to consider recent research from Northern Trust and JP Morgan which sets out return expectations for a variety of different hedge fund strategies.

Selection of Hedge Fund Managers

The dispersion of returns between managers is vast – far more than between actively managed equity portfolios. Data from Morgan Stanley for the period 2008-2014 reveals that, on average, there is a 17% pa differential between the 75th percentile and the 25th percentile of returns. In fact, performance differentials within strategies are often more than those between different strategies.

Hedge Fund manager selection and due diligence is therefore crucial. One of the most popular papers on this subject on the Savvy Investor site is this eight page document from Merrill Lynch:

Merrill Lynch (2015) – Hedge Fund Investing: Manager Selection and Due Diligence

As the name suggests, this paper analyzes the various components of the hedge fund manager selection process, discussing both investment due diligence and firm/business due diligence. This includes operational risk, compliance and regulatory issues, HR and resources, and company ethos and transparency.The paper highlights the value of using a professional intermediary to carry out due diligence, given the specialist expertise required. 

Wells Fargo Prime Services (2013) Understanding Investor Due Diligence

This 2013 paper, informed by investor discussions, aims to help hedge funds seeking to raise funds, by setting out the processes typically used by investors in the due diligence process. The typical process described begins with qualitative due diligence factors, classically described as the three Ps pf people, process and philosophy. The report then moves into a discussion of quantitative due diligence factors, under the headings of performance, risk, and attribution analysis.

PIMCO (2013) A Quantitative Framework for Hedge Fund Manager Selection

PIMCO sees quantitative due diligence as complementary, but not a replacement for qualitative due diligence. Their quant framework for choosing hedge fund managers particularly favours managers with low exposure to market beta, but who have generated alpha at a statistically significant level. Their analysis attaches significant importance to the t-statistic of alpha, believing this to be a meaningful indicator of performance persistence.

Brown, Fraser and Liang (2008) Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy

In this popular paper from 2008, the authors argue that effective due diligence should be seen as a key source of alpha in a FOHF or hedge fund portfolio.

Sameer Jain, UBS (2011) Implementing a hedge fund portfolio

This short paper from UBS sets out a due diligence process for hedge fund manager selection.

Cambridge Associates (2013) Hedge Funds: Value Proposition, Fees, and Future (2013)

In this 12 page paper, the author’s argue that hedge fund managers should be assessed on the basis of their “value proposition”, as exhibited by their investment process, terms of business and operational proficiency. The paper examines what each of these mean in practice.

Pavilion Advisory Group (2013) Factors to consider when selecting managers

In this short paper, David Finstad of OMERS, provides evidence that the performance of boutique hedge fund firms is superior to that of institutional hedge fund firms.

Barclays Wealth and Investment Management (2012) The Science and Art of Manager Selection

Barclays discuss their process for manager selection, describing some of the key quantitative and qualitative tools which they use in the manager research process.

Lyxor Asset Management (2014) Hedge funds in strategic asset allocation

This bumper 60 page study from Lyxor examines the risk factors and correlations associated with a variety of different hedge fund strategies, explaining the excess return from each strategy in terms of alpha and beta (both traditional and alternative). The authors argue that, when integrating into a multi asset-class portfolio, some strategies work well as “equity substitutes”, whereas others should be seen as “bond substitutes”.