How To Perform Due Diligence On Hedge Funds

RESEARCH PERSPECTIVE VOL.13 JANUARY 2016 Alexandros Kyparissis Hedge Fund Analyst Tel.: +447843144007 Email:alexandros.kyparissis@stonemountain-capital.com   How To Perform Due Diligence On Hedge Funds Investing in hedge fund industry is dissimilar to investing in traditional long only asset classes, where there is publicly available information on them and the investment access is relatively easy to the general public. Hedge funds are available for high net worth individuals and institutional investors (accredited investors in the US and professional investors in the UK), who have the ability to understand the inherent risks within their asset allocation strategies. Hedge funds were vastly considered as a tool for diversification during the previous decades, but with the bullish sentiment ruling the equity market and the low interest rates, their popularity is increasing. Hedge funds and investors are both relying on third-party marketers or even online databases to establish a connection between them and build a profitable relationship. The first and most important step towards the building of a hopefully long-term and successful relationship is the due diligence process. Effective due diligence constitutes a source of value added to investors’ portfolio who have to decide between a pool of funds, making their analysis of disclosed information crucial. Apart from performance reasons, due diligence’s importance emerges when it comes to risk mitigation, especially in eliminating operational risks which are the impetus for a lot of hedge fund failures.   Due diligence should be based on two pillars and subsequently scrutinizing thoroughly every aspects of these pillars which are operational and investment due diligence. Operational due diligence should focus on the investment objective and the process of the fund while investment due diligence should concentrate on identifying alpha (α)-generating sources. In the premises of regulators’ demand to underline that past performance does not guarantee future results, the investment objective should divulge the markets and the asset classes they invest alongside with the benchmark they aim to outperform. The investment objective allows investors to access the dynamic performance of managers and their adjustability to market condition. The objective aids in avoiding misunderstandings and conflicts between managers and investors, who think that the goal is to make money and not outperform the market.   Moving to the investment process, its necessity for providing insights on how decisions are carried out and controlled is highlight. In our modern days, there are two processes in the hedge fund industry: the old-school fundamental and the computer-driven. Apart from the operational risk mentioned above, at this stage we should mention the investment process risk which arises from the incorrect execution of the designed strategy. The strategy needs to be tailored to the investors’ preferences and to a variety of factors that will ensure the success of the strategy and reflect the trust between manager and investors. This trust is ensured by the key personnel clause that allows investors to withdraw their money without a penalty in case the key person departs from the fund. In the computer-driven case, things are more complicated, as heavy stress-testing needs to be applied to the black-box trading system to ensure its functionality and robustness, which constitutes the value added in their portfolio. What should the investors really do and review before they allocate their wealth to hedge funds? The new first step of due diligence is conducted easily online with the use of Google’s search machine, which highlights the need for good online reputation. Next step is to review the regulatory body the fund complies with and validate its accuracy via the respective regulator’s registration search machine. In addition to the regulatory framework, they are keen on knowing the fund’s structure, which could be either onshore or offshore, depending on the investor’s base. From a European perspective Cayman or British Virgin Islands are the typical offshore structures with Luxemburg, Ireland and Malta to be considered as the main onshore structure. Some funds in Europe and especially Germany, France, Italy or Spain have local structures where only local investors allocate due to tax considerations. In the US, the typical master - feeder structure exists (mater is offshore and feeders are onshore e.g. Delaware and offshore Cayman). All other countries are offshore for US. Additionally, the investors should review and more importantly understand the type of partnership they are getting involved with. Sometimes investors force their opinion into fund’s day to day management which makes their limited liability shield void and leaves them exposed to huge legal risks especially when the fund is applying leverage to augment its performance. Consequently, the investors should monitor the levels of leverage, if used, and legally bind the managers to comply within reasonable boundaries. Key to the investors’ due diligence is the people involved both internally and externally with how the business is run. Experience and reputation is what matters in the management team and the service providers. Big names attract big wallets because well-known institutions already co-operate with service providers of the highest caliber which create a sense of trust and transparency. Subsequently, this leads to a quicker and stronger reference for the managers.   Subscriptions are another important aspect in the funds’ operations and in its availability to investors. Hedge funds have a high minimum required participation usually ranging from 1 to 5 million depending on the type of investor and limit the investor slots by defining the maximum capacity of the fund. On the other side, the fund and investors should be aware of the redemptions risk in the operation and performance of the fund which is rising respectively with the absence of liquidity. Single managers usually require 30 and fund of hedge funds up to 90 days notice period before the defined redemption date so they can adjust their strategy without affecting the performance. Problems arise when redemptions happen often, especially during turbulent market conditions. To tackle with these problems and to protect their investments, managers sometimes use gates or soft and hard lock-up periods, terms which are not well regarded by investors especially after the financial crisis of 2008. Investors want liquidity and most of the funds offer it on a daily, monthly (for single managers) or quarterly basis (for fund of hedge funds), a fact that makes the fund attractive to investing supposing the non-existence of gates, soft and hard lock-ups.   Investment due diligence is the second part of the overall diligence and includes the review of the fund in terms of returns, track record and risk. The majority of investors want a proven track record of usually five years, high returns preferably double-digit and low volatility. However, there are challenges in the performance and risk measurement of hedge funds due to the distinct differences between them. In the simplest way, an investor would look only at the number of returns to decide which would be a good investment if all the hedge funds were implementing the same strategy and leverage. In the realistic case, investors are trying to measure α which is the reason for investing in hedge funds due to the infamous ability of hedge funds to beat the market. Identifying the distribution of returns is key in quantifying manager’s ability to produce α, especially in a hedge fund industry where there is evidence of non-normality due to the existence of short positions and leverage. Lhabitant (2004) specifically evidences elliptical patterns in hedge fund returns which add to the idiosyncratic character of hedge funds. The fact that α is unobservable highlights the necessity of a robust model to capture α which will allow investors to distinguish between manager’s ability and systematic risk. The problem with α is that α is dynamic and heavily depends on the strategy, i.e. event driven strategies have periods of extremely high alpha and eras of zero alpha. Secondarily, α is computed based on historical data which may lead to estimation risks and does not allow for sophisticated forecasting. Alpha can be captured by single factor models like CAPM or multi-factor models including fundamental, macro, market and statistical factors. At this point, investors should be careful when using these factors and especially statistical factors due to spurious correlation that may arise.   This perspective given the nature of the hedge fund industry suggests measurements based on downside risk and higher moments and not absolute or relative-risk adjusted techniques or any other conditional beta method. The only absolute-risk adjusted method that is widely used is the infamous Sharpe ratio. Although, despite its conceptual simplicity, it is based on the assumption of normal distribution and its main disadvantage is the treatment of volatility. Investors are concerned about downside volatility because upside volatility is always welcome, especially in a leveraged strategy. The solution to this problem is Sortino ratio, which is considered as an augmented version of Sharpe because it accounts only the downside deviation of returns and the excess return over a discretionary hurdle rate. For capturing higher moments of distributions, Omega ratio is used which also accounts for separating gains and losses over a discretionary threshold.  Kappa 3 ratio is another measurement similar to Sortino but accounting for higher moments than Sortino. Hedge funds justify their high fees with superior returns and sophisticated risk management, so on that premises they should be judged with drawdown-based measurements. Drawdown is defined as the maximum consecutive losses over the investment span of the fund. Calmar ratio is a robust ratio indicating the ability of the manager to produce better gains than losses.                                                The measurements mentioned above do not constitute the whole spectrum of measurements but constitute sufficient tools for effective and α-adding due diligence process. The complexity of computations and their rationale makes investment due diligence very specialized, which should be conducted by really sophisticated individuals. Misunderstanding or false measurement can lead to bad investment allocation decisions and wrecked portfolio returns.   This perspective is neither an offer to sell nor a solicitation of an offer to buy an interest in any investment or advisory service by Stone Mountain Capital LTD. For queries please contact Alexandros Kyparissis under email:alexandros.kyparissis@stonemountain-capital.com and Tel.: +44 7843 144007.   For further information around our research and advisory services please contact Oliver Fochler under email:oliver.fochler@stonemountain-capital.com and Tel.: +44 7922 436360.   The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, Stone Mountain Capital LTD. Readers should refer to the Disclaimer.   STONE MOUNTAIN CAPITAL   Stone Mountain Capital is an advisory boutique since 2012 and we are mandated from 30+ best in class single hedge fund and fund of fund managers across equity, credit, and tactical trading (global macro and CTAs). 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