- The gap between the best and worst hedge fund managers is double that of traditional global equity managers.
- Investors must constantly monitor the managers they've selected and watch for potential problems.
- Hedge fund managers are not held to the same standardized reporting requirements as many long-only managers.
The hedge fund universe is vast — there are now more than 8,000 managers — and difficult to navigate. Without careful due diligence, investors may quickly find they’ve selected a subpar manager. To move beyond run-of-the-mill managers and performance, it is crucial that investors conduct thorough due diligence. Quite simply: manager selection matters.
The hedge fund industry attracts managers for many reasons, one of which is the fees charged. This popularity has the potential to allure the very best, but also mediocre, talent. This can be troublesome, as the hedge fund industry is complex and invests across all asset classes using techniques such as short selling, arbitrage and leverage, therefore requiring highly trained professionals.
For example, hedge fund managers are not held to the same standardized reporting requirements as many long-only managers. Hedge fund managers also differ widely in the strategies they use and are not constrained by a benchmark. Further, managers can shift their portfolios as they deem appropriate, dependent on market opportunities and the environment. As a result, their performance dispersion — the gap between the best and worst — is double that of traditional global equity managers and even greater for other investment categories.
For the three years ending March 30, 2013, the median hedge fund returned an average 4.94% per year. But the dispersion between the 10th percentile and 90th percentile funds was 30%. In contrast, the 10th-to-90th percentile dispersion for all global equity funds was only 13%.
The takeaway: the extra time and effort invested to identify and select the very best hedge fund managers can pay off.
The Art and Science of Manager Selection
Comprehensive due diligence should examine three areas: the investment process, operations and compliance.
- Investment process due diligence should combine both qualitative and quantitative aspects.
From a qualitative perspective, successful hedge fund managers tend to possess certain traits, such as dedication, focus and specialized expertise. These traits can best be identified through:
- extensive discussions
- on-site visits
- an examination of their personal investments in funds
- determining whether the manager has successfully identified opportunities through various market cycles
- confirming whether the manager has a repeatable investment process
The quantitative assessment should go beyond peer group comparisons to include risk management techniques and a multifactor analysis of performance.
- Operational due diligence should evaluate each manager’s operations and control environment, reviewing processes, policies, procedures and audit reports. It should also examine business continuity and disaster recovery plans. This is extremely important in understanding whether managers have all the tools and procedures in place to support their business.
- Compliance due diligence involves a team that evaluates the manager’s practices on legal and regulatory requirements.
At Northern Trust, we believe it is imperative that three separate and independent teams conduct each of the three evaluations. Each team must be empowered to question — or even stop — an investment for the right reasons. A prospective hedge fund manager should be able to pass all three phases of the due diligence process to merit consideration. This is very important, as the investing environment is challenging enough, so it is critical to mitigate any administrative or infrastructure issues from the managers. Given the time and resources that are required in this process, investors might not possess the expertise to conduct this three-part review or to evaluate the results. In these instances, a third-party manager-of-managers could provide the necessary resources.
Constant Monitoring, Communication
Given the flexible nature of hedge funds, investors must constantly monitor and communicate with managers with whom they are invested — in addition to performing the initial due diligence review — and be aware of signs of potential problems. As the disclosure goes, past performance is not indicative of future results. Some strategies are cyclical, such as distressed investing, which is dependent on default cycles, or merger arbitrage, which is driven by the mergers and acquisitions environment. Meanwhile, the forward-looking opportunity set might not be as robust as it once was, meriting a rotation out of certain managers.
In addition to market cyclicality, managers also go through life cycles, and this bears monitoring. For example, style drift is a common investment concern and often occurs when a hedge fund that specializes in a strategy that’s out of favor seeks to shift into areas outside their expertise. Or, significant asset growth in a fund sometimes prices them out of their investment opportunity set and limits previous nimbleness.
“If a manager drifts into a different strategy, especially one they aren’t best-suited for, that would be a red flag,” said Brian Tam, research analyst and member of Northern Trust’s Hedge Fund Manager Research Group.
In addition, wading through the vast amount of data available on hedge fund managers and conducting thorough analysis of the information is key. An investment manager with these capabilities and resources is able to take a holistic look at the portfolio.
“Just 10 years ago, many people considered the hedge fund industry a black box, where you didn’t know where your money was being invested,” said Aimee Wight, investor relations representative for Northern Trust’s Hedge Fund Group. “Now, with the right hedge fund managers, an investor can fully understand a manager’s investment strategy and how they are taking risks and, if something changes, you know when to exit. It’s not just about investing with the right managers, but also about understanding when to exit.”
Hedge Fund Strategy Outlook Now Available
The Northern Trust Hedge Fund Group has released the “Hedge Fund 2014 Outlook.”
Hedge funds are speculative in nature and may use leverage or other aggressive investment practices. As a result their returns may be highly volatile, and you may lose all or portion of your investment in the fund. In many cases the underlying investments in a hedge fund are not transparent and are known only to the investment manager.
Hedge funds often are not subject to the same regulatory requirements as other investment vehicles including mutual funds. Hedge funds may involve complex tax structures and delays in distributing important tax information.
Hedge funds may have higher fees and expenses than other investment vehicles, and, in addition to underlying direct fund fees, funds of funds also charge fees and expenses.
Hedge funds, both the unregistered and registered variety, are highly illiquid investments and are subject to restrictions on transferability and resale. Requests for full redemption of hedge funds can be subject to a 10% holdback, which may not be distributed until the annual audit of the hedge fund is completed. There is often no secondary market for an investor’s interest in alternative investments, nor is one expected to develop.
Each investor should consult his own advisors regarding the legal, tax, and financial suitability of investing in hedge funds or other alternative investments.
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