Due diligence key to hedge fund investing

Downturn reveals that some managers of funds of funds didn't look under the hood or kick the tires

Oct 18, 2009 @ 12:01 am

By Daniel A. Strachman and Richard S. Bookbinder

The losses of 2007 and 2008 in the [hedge]-fund-of-funds industry showed us that some funds of funds turned out not to be as diversified or non-correlated as they claimed and that some funds of funds were not performing the level of due diligence required to avoid the problems experienced by others. The events of 2007 and 2008 demonstrated that strategies that were supposed to be non-correlated were in fact correlated, and managers were exposed when the financial markets ceased to function. Trades were taking place, but not at rational levels. We believe that many funds of funds were not doing enough research into portfolio management, and as a result, their performance did not deliver the steady results they once provided. Remember, however, that one bad apple does not spoil a bunch, nor does it mean that the whole industry is spoiled. Quite the contrary; the funds-of-funds industry is alive and well, and thriving in the post-meltdown world. That's the beauty of what the hedge funds industry is all about. To use another produce analogy, if you peel back an onion, you find various layers, one after the other, until you finally reach the core. The same can be said for the funds-of- funds industry. Due diligence is the knife that lets you get to the core and allows you to find the right fund to fit your specific needs. The hedge fund industry is multilayered as well. It truly offers something for every investor, regardless of the level of assets. Whether it's a multistrategy fund, a separate-account product, a sector-based or diversified fund of funds, or even many different single-manager products, the industry has something for everyone. The problem is figuring out the right fit. Never settle for unsophisticated due diligence or poor manager selection processes. They will do you in. PLAYING BOTH SIDES Investors understand the value proposition of being able to go long and short the market. There is a simple truth that everybody who invests understands: Markets don't always rise. One needs to be prepared to make money when markets rise as well as when they fall. Hedge funds are supposed to be the tool that delivers on that need and fulfills that promise. Funds of funds are supposed to create diversified portfolios of hedge funds that meet and exceed this expectation. What we learned in 2007 and 2008 is that many funds were unable to fulfill that promise or deliver on that need, and as a result, many funds of funds did not diversify their investment portfolios. In other cases, fund-of-funds managers invested in strategies that they did not fully understand; they just wanted to follow the crowd. This tells us one thing of great importance: We need greater levels of due diligence. We need to understand how money is managed on all levels. As investors, we bear the responsibility to ask questions and get answers. It's the responsibility of the money manager to provide good answers, and it's the responsibility of the investor to follow up and confirm whether or not those answers are true. This is not something that stops once the investment has been made; it is something that is ongoing and should be done continuously. Funds of funds get paid for post-investment monitoring and review.

The lesson we've learned is not that not all hedge funds are bad, not all funds of funds are evil, and not all separately managed accounts are negative. What we've learned is that we must do due diligence. That is certainly not something that we learned yesterday or three years ago or one year ago; it's something that everybody has known. But because of the pace of growth in the industry and the pace of growth of those providing services to the industry, we think that due diligence has been lacking because people just did not feel they had to do the work. Now they know the consequences.

STILL, WE BELIEVE

We think there's an opportunity to continue to achieve non-correlated returns in hedge funds and funds of funds, and that each provides a unique and different service within the marketplace. The key is for investors to make sure that the funds to which they allocate deliver on the promise that they offer. Due diligence involves understanding how money is being managed, by whom, and who is checking on it to make sure the data are correct. It's about asking questions, getting answers, making sure the answers are understood, and making sure that what you see is really what you get.

What we've learned since 2007 is that a lot of what we saw was not what we got, and the only way to ensure that it is is to have constant contact. It's a matter of following up, demanding meetings, and making withdrawals if you don't get the answers you want. There are plenty of good money managers out there; the hard part is finding them. Once you find the ones you like, make sure you establish a good relationship with them. It is a lot of work, but it's your money so, to quote Nike Corp., ‘‘Just do it!''

It's important to realize that if you, as an individual or institutional investor, have a relatively modest amount of money to invest, somewhere less than $5 million, funds of funds are probably the best way to access the hedge fund industry.

However, you still need to perform a substantially high level of due diligence. If you are an institutional investor, funds of funds can be even more important, because you are able to offload a significant amount of the work to trained professionals as opposed to doing the work yourselves. Again, you still need to be constantly performing due diligence.

We don't believe that funds of funds or single-manager strategies are the be-all and end-all for everybody; nothing is. Everybody is unique, has different issues, different wants and different needs. And frankly, everybody needs different money managers and different strategies.

The only thing that determines whether the investment choice is right for a particular portfolio instead of someone else's is that the investor believes that the manager will deliver on the promise made in the marketing pitch, in the meetings, and in the performance once the money has been invested.

It's not saying, ‘‘Well, you're a square hole, so we'll put the square peg in you.'' No, it's quite the opposite. It's finding out what actually fits instead of just trying to fit something to what you need.

When you make an investment, you must make sure that it is the right investment for your specific needs.

Reprinted from “Fund of Funds Investing: A Roadmap to Portfolio Diversification” by Daniel Strachman (at hedgeanswers. com/blog) and Richard Bookbinder (John Wiley & Sons Inc., 2010).

For archived columns, go to investmentnews.com/advisersbookshelf.

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