How investors should vet hedge funds

With the return of volatility, investors have to get reacquainted with the process of finding the right hedge-fund strategy

How investors should vet hedge funds

After lagging equity index returns for almost a decade, it seems hedge funds, with their promise to do well in all manner of markets, are set to resurge. Looking back to the stock plunge of 2008, data from industry tracker BarclayHedge show that diversified commodity trading advisers gained 14%; equity market-neutral funds also preserved capital well, losing just 1% compared to the 37% decline of the S&P 500 index.

Since not all managers can offer that degree of performance or protection during a downturn, it is important to find the right one. “While hedge-fund strategies might seem mysterious, the vetting process for these investments should be straightforward and transparent for the most part,” wrote Wall Street Journal contributor Eric Uhlfelder. “If it isn’t, you probably should move on.”

A case in point is Stillwater Capital, a former fund of hedge funds that passed on the opportunity to invest with Bernie Madoff in 2006. “[W]e couldn’t receive key documents to perform even basic due diligence,” explained Jonathan Kanterman, a former managing director at Stillwater.

According to Kanterman, the documents needed for proper due diligence include the fund overview, monthly performance report, due-diligence questionnaire, audited financials, Form ADV, private-placement memorandum, investment-adviser public disclosure forms, and prime brokerage statement. Even with all these materials, investors shouldn’t expect to have all their questions answered, but they should expose points that may need further investigation.

Investors may also look to the tone and substance of the responses they receive from a manager. Often, they provide hints on the integrity and effectiveness of the manager not just in making money, but also in containing losses during a sharp or extended selloff.

When it comes to preserving value, hedge funds typically either count on their investments to ride out volatility, or they have short, hedging, and deleveraging strategies and stop-loss orders that will be triggered in case of market freefall. While managers should be able to explain their risk-management strategy clearly, many have actually have an inherent long bias and don’t go much further than lip service when it comes to risk mitigation.

“If managers are unable or unwilling to identify their short positions and how they go about finding them [beyond market indexes], it suggests their research and expertise is more focused on long exposure,” said Jeff Willardson, managing director at Paamco Prisma, a US$30-billion fund of hedge funds. “[They] aren’t likely prepared for challenging market conditions.”

Another telling metric, the maximum drawdown, shows how much a fund’s value has fallen from a peak to a trough before surpassing that initial high. While the broad market will directly impact the drawdown for virtually all strategies, a hedge fund’s focus will impact the degree of drawdown; an equity long-bias fund is more prone to volatility and drawdown than a global macro fund, for example.

But the severity of a fund’s monetary losses also reflects specific characteristics and risks such as quality of research and management, asset exposure, leverage, valuation and risk controls.

“[Find a manager] who can explain and demonstrate a clear, articulate and repeatable investment process, which helps distinguish performance generated by luck versus skill,” emphasized Willardson. 


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