Although institutions have been conducting due diligence on investment managers for years, their routine protocols mainly focus on the qualitative side. Thus, the main drawback of commonly used due diligence frameworks is a lack of the quantitative component, arguably most important.
Over the last decade, we have been witnessing a degrading quality of large institutional investors including their own investment research and outsourced due diligence. That trend has become obvious after collapsing the giants like Lehman Brothers or Bear Stearns, however, its causes have never been investigated in details.
A sophisticated hedge fund due diligence framework should assess all applicable risks – not only their non-quantifiable segment. Our proprietary due diligence routine includes evaluation of the complete range of risk categories: Market, Liquidity, Volatility, Concentration, Strategy, Currency, Operational, Legal and Fraud risks.
The methodology of due diligence on hedge funds presents a controversial topic, mostly because of a strong qualitative bias of traditional institutional investors. Such a bias leads to ignoring or underestimating most investment risks that have to be quantified. Our standpoint on due diligence could be summarized as follows...
We are not going to delve into endless discussions of how Bernie Madoff has successfully managed to defraud hundreds of investors for years. We will not talk about the reasons of the SEC’s dereliction, when the latter was supposed to examine the Madoff’s books since 2006. All these aspects are largely irrelevant for us.
The unique hedge fund risk assessment problems arising from numerous causes like non-normality of their distributions of returns, bizarre hedge fund indices and data biases are not new. One may easily find hundreds of articles and deep researches on the subject as well as a few proven investment frameworks offering feasible solutions by enhancing the commonly used risk metrics.
Low transparency of hedge funds is often viewed as a key risk factor of alternative investments, while the term transparency is referred to fund asset allocations. Such a standpoint ignores the fact that the degree of investment risks depends on the way of structuring assets in the portfolio, rather than on assets themselves.