To avoid last year’s slump, hedge fund managers should pay closer attention to operational risks and look to their peers to gauge performance, suggests Mercer Investment Consulting, Inc.
Investors must ask tough questions up front and spend more time on operational due diligence, said Jeff Gabrione, a Chicago-based senior consultant with Mercer IC who specializes in hedge funds.
“By some accounts, up to 50% of all hedge fund collapses are the result of operational failures, particularly misrepresentations, misappropriations of funds, and unauthorized trading,” Gabrione said. “Investors were reminded of the important role that non-investment due diligence plays when selecting hedge funds and the need for them to fully integrate operational issues into the investment decision-making process.”
Non-investment due diligence includes accounting practices and valuation methods; legal structure, regulatory, and compliance policies; trading, settlement, and execution procedures; human resource practices; implementation of technology; review of service providers; and management and governance practices.
In order to deliver the level of returns necessary for many actuarial assumptions, some investors will consider specialized, or focused, fund of hedge funds instruments, says Mercer.
Most investors rely on a diversified fund of hedge funds approach. Sometimes they require more upside return potential than the broad strategy offers but cannot accept leverage.
Focused funds of hedge funds serve this need while preserving some of the benefits of a broadly diversified approach. While these funds come in many different varieties, the most popular are market neutral and equity long-short products.
“This specialized strategy can serve either as a complement to a broadly diversified strategy or as part of a portable alpha program,” Gabrione said. An investor gets the risk-mitigating benefits of the fund of hedge funds structure, but can better match specific risk-return considerations than a traditional, broadly diversified fund of hedge funds. “Similar to other investment decisions, investors must be comfortable that the manager has expertise within this specialty,” he added.
After a year when hedge fund returns overall seemed disappointing relative to past performance, Mercer IC stresses the need for benchmarking managers.
“Over a three-year period, successful managers ought to attain their stated targets,” Gabrione said. “Peer comparisons are the next most effective means of benchmarking performance.”
Gabrione also suggests that investors compare the hedge fund’s performance to an index for a rough gauge of opportunity cost.