Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Summary

Performing due diligence on a hedge fund is as much art as it is science. An investor must use a comprehensive checklist to ensure that nothing is left out or omitted yet remain free to ask open-ended questions that provide insights into a firm's philosophy or culture. The guidelines discussed here for investment, operational, and business model risk assessment were for the most part generic. When performing due diligence, investors must modify their approach to be strategy specific. An equity fund requires a different set of questions about its portfolio than a fixed-income fund or a risk arbitrage or distressed fund. An investor in an equity manager might care about the portfolio's beta, whereas an investor in credit is concerned about spreads and rates. Due diligence includes analysis of the investment process, the operational environment, and the fund manager's ability to run a business.

Every fund is unique, and the process is fluid. In the end, an investor needs to balance a set of minimum standards and values with those identified during the due diligence process before deciding to invest. Although there will always be exceptions, it is useful to follow a particular regimen and uniform process when evaluating investments in hedge funds. Doing so ensures a certain amount of efficiency and consistency and ultimately helps investors manage performance and risk expectations over time.