The methodology of due diligence on hedge funds presents a controversial topic, mostly because of a strong qualitative bias of traditional institutional managers. Such a bias leads to ignoring or underestimating most investment risks that have to be quantified. Our standpoint on due diligence could be briefly summarized as follows:
- Due diligence on hedge funds adds up to assessing all the applicable risks, i.e., market, credit, concentration, liquidity, strategy, operational, legal and fraud risk.
- A robust due diligence system needs to incorporate both the constituent parts - qualitative and quantitative. Any bias prioritizing one part over another, results in ignoring some risk groups.
- A quantitative component of due diligence needs to address numerous peculiarities and irregularities of hedge funds, such as Non-normality of distributions of returns, which results in inapplicability of the mean-variance methodology to hedge funds and, in turn, inapplicability of the standard deviation as a measure of risk. Inconsistency of hedge fund indices, which leads to inconsistency of the comparative benchmark analysis.
- Short data series that requires employing advanced statistical techniques to meet the given confidence level.
- Non-transparency of hedge funds. That drawback makes a few groups of risk (market, credit and liquidity) difficult to quantify.
- Manager style drift. While this phenomenon is widely recognized, it is rarely measured and applied in practice. Certain risk categories like credit and strategy risks are commonly overlooked, when investigating hedge funds.