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

Remember, It's Still about Returns!

So much media and regulatory focus has been placed on the need for hedge funds to raise their standards and adhere to best practices, particularly related to operations, credit risk, and liquidity, that it is entirely possible for some investors to actually overemphasize some aspects of the due diligence process. Investors may place so much emphasis on operational due diligence alone that they end up picking managers with great controls that actually don't add much return to the portfolio at all. Investors should be mindful not to overweight infrastructure and business model risks. There needs to be a good balance between the investment opportunity and the risk profile of the fund. A set of minimum standards or bright lines is helpful to ensure that the balance doesn't shift too far in the other direction, resulting in the selection of managers with great strategies and poor controls or business risk. The need for independent administration, audits, and top-tier service providers is generally not negotiable. However, infrastructure and business models should be strategy and life cycle specific. A recently launched equity variable bias fund operating in the United States may not need multiple prime brokers, real-time disaster recovery, and a hot backup or succession plan, certainly not all on day one! The reason investors invest is to increase return and to reduce risk. As simple as that sounds, it can easily be forgotten.