Much has been written about the "perfect storm" of corporate accounting scandals, pension crises and subsequent legislative backlash, which resulted in a decline in the funded status of defined benefit plans as well as an increase in the expense recognition and contribution requirements for those plans. Hindsight now reveals that these problems might have been avoided if investment strategies had provided a better hedge for managing the volatility risks related to financial statement disclosures, expense recognition and funding requirements.

The Need for Higher Returns

The expectation of lower returns in the near future is forcing investors to shift their investment strategies. "Liability-driven investing” and other investment strategies have suddenly become topics of great interest for plan sponsors seeking to avoid future financial volatility. Typically, these strategies depend upon the proper use of derivatives, leverage and shorting—techniques that appeared too risky for many plan sponsors just a few years ago. The use of hedge funds and hedge fund of funds has rapidly increased among European-based plans and is on the rise in the United States. For the growing number of plan sponsors that are considering these investment alternatives and have progressed to the point of trying to select an appropriate fund of funds manager, there are many potential challenges.

Currently, there are hundreds of hedge fund of funds available. The vast majority of these funds remain unregistered with the U.S. Securities and Exchange Commission (SEC) and disclosure information is not standardized. In addition, there is limited historical performance data available and even the basic investment strategies and instruments are not readily transparent. How can plan sponsors and other prospective investors be certain that they have performed proper due diligence during the manager selection process?

Hedge Funds: Assumptions vs. Reality

Hedge funds are often misunderstood and, as a result, continue to be challenged by vast generalizations, misconceptions and bad publicity. It doesn’t help when the failure of a single fund—such as Long Term Capital, which, in 1998, lost $4.6 billion in less than four months; or Amaranth Advisors, which, in September 1996, collapsed after losing roughly $6 billion in a single week on natural gas futures—becomes a prominent example of the risk potential in the hedge fund industry. It is often assumed that all hedge funds share the same negative characteristics including:

• Extensive leverage
• High failure rates
• Speculative investing
• Extremely high degree of risk
• Low transparency
• High fees
• Tax inefficiency
• Illiquidity

Indeed, some funds typify this unfortunate profile. On the other hand, there are many funds—single manager hedge funds as well as hedge fund of funds—which do not operate with these risk characteristics. Given proper time and a concerted due diligence process, a potential investor should be able to carefully evaluate a fund of funds’ various attributes and form a balanced picture of the associated risks and rewards.

Due Diligence Process

In many ways, the due diligence process for selecting an alternative investment manager is similar to that of selecting a mutual fund manager. The primary task involves evaluating the team (likely comprised of internal resources, attorneys, investment advisors, analysts, accountants and actuaries), to verify that the manager is positioned to deliver the target returns or investment objective as described to prospective investors.

While there are many questions that prospective investors should ask a potential hedge fund manager, this article will focus on 10 critical areas of concern.

First, an investor will need to investigate the robustness of the underlying organizational structure and operational procedures, which cover areas such as reporting, investment management and risk management:

1. Firm Ownership and Management

   Who are the principal owners? Is the firm owned by another entity? If so, do the firm and its owner have a positive relationship or is it fraught with issues? Have there been any lawsuits brought against the firm?

   Have there been any ownership and/or organizational changes? If the founders have left, find out why and who replaced them. High turnover in positions requiring skills critical to the viability of the hedge fund should also be questioned.

   What oversight exists? Who conducts audits? Ask about internal as well as regulatory controls. If the fund is a Registered Investment Advisor, then the SEC has regulatory authority.

   Does the fund operate offshore or is it domestic? If offshore, what are the potential tax issues for an individual or corporate investor? Be sure to understand the implications as well as any legal processes involved, including the likelihood for success should problems arise with managers in foreign jurisdictions.

   How much of the principals’ and/or managers’ own money is invested in the fund? To align the interest of the managers with those of the investors, both the fund of funds manager and the sub-fund managers should have a significant portion of their individual net worth invested in the funds so they have a personal stake in its success. Similarly, investors could confirm that all employees are solely dedicated to the operation of the fund, and that there are no potential conflicts of interest arising from anyone receiving income from outside the firm.

2. Operational Structure

   What is the depth of experience and sector specialties of the portfolio management team members? How long has the team been working together? What are their employment and educational backgrounds? Investors should verify biographical information whenever possible and perform internet searches for additional validation and to learn more about the people they will be working with.

   What is the size of the employee base and their overall experience? Apart from operations, how many individuals are dedicated solely to research? To legal and compliance? To trading? What are the employee growth and turnover statistics? The sub-funds should also have a stable employee base.

   Is there a disaster recovery and business continuation plan in place? Have they been tested? If so, what were the results?

3. Investment and Risk Management Process

   How are investment decisions made, both at the individual and fund of funds level? Who or what department has veto power over an investment decision, and why?

   How does the firm evaluate and manage risk? Prospective investors should be cognizant of the interaction between the fund and compliance and legal departments.

   Who manages any potential conflict of interest between the management principals and the fund manager, or between the fund manager and the sub-fund managers? Processes to address these various issues should be clearly spelled out in a firm’s risk management policy, which either should be written or able to be clearly described with evidence of how it is followed.

Next, the investor should ask the following questions regarding the investment fund itself:

4. Investment Objective

   Does the fund target a specific return or adhere to a specific investment strategy? Have these objectives been consistent over time or have they strayed to “chase” returns? Some fund of funds are diversified across many investment styles (also known as a “multi-strategy”), while others are designed to capture the best hedge funds working in a specific investment style (“multi-manager”). Investors should know which of these two categories a fund of funds falls into in order to gauge how well it and its manager’s investment decisions track with stated objectives.

5. Investment Capacity

   What is the current size of the fund? Can it accommodate future expected deposits by investors? How large can the fund become, while still maintaining its integrity of style and stated investment objective? The manager should exercise particular discipline with the fund, from showing a willingness to close the fund to new investors once it has grown to a particular asset size, to carefully managing its fluidity with regard to taking advantage of opportunities or adjusting for underperformance.

6. Fee Structure

   How are managers paid? What costs are passed through to investors? Fund of funds may have multiple fees: those paid to the manager of each sub-fund and those paid to the fund of funds manager. Some fund of funds are mindful of the fee burden on investor returns and are trying alternative fee structures. Investors should ask about their options, including reduced fees for larger-than-average investment amounts.

7. Investment Process and Performance

   What is the investment process? Is it repeatable, or does it depend on a “superstar” portfolio manager? This is a critical issue for many funds where one or two key individuals control the success of a fund and are closely linked to a firm’s succession planning. The firm should have evidence or an example of executing the investment process to show how it addresses the issue of a potentially significant disruption in performance as a result of a key employee’s departure from the fund.

   How has the fund performed in up markets? Down markets? Flat markets? Has its performance been consistent with its stated objectives and, if not, can the reason be identified? What has been done to rectify the situation?

   What is the process that controls the fund “mix”? Is diversification or lack of correlation the controlling issue or do other factors come into play? What guidelines exist to avoid duplication of style and exposure to securities, ensure the risk is spread appropriately and manage the degree of leverage generated by utilizing multiple sub-fund managers?

   For the sub-funds, what is the process to evaluate funds? What goes into the decision to add or remove a fund manager?

8. Liquidity

   How is liquidity managed? Investors should be aware of the minimums and maximums imposed on deposits and withdrawals, especially with regard to transactions and timeframes. When are the liquidity windows? Every quarter? Once a year? How long is an investor’s money at risk? What if a manager leaves and the investor doesn’t like the new team? A fund of funds investor typically has few redemption rights, while fund and sub-fund managers have extreme latitude in controlling the outflow of funds, including unilateral termination of the fund itself.

9. Pricing and Valuation

   How is pricing determined and with what frequency? Is there a valuation committee that determines standards for accuracy, including an independent audit procedure to verify the integrity of the pricing? What is the role of the outside auditor in this process? How does the fund value illiquid investments?

10. Risk

    What is the maximum exposure to one security? One asset class? One sector, etc.? Does the fund manager use derivatives? What controls are utilized to manage risk in the event that sub-fund managers also use them? How frequently does the manager assess the risks of the entire portfolio?

By evaluating hedge fund of funds and their managers with respect to the numerous qualitative and quantitative criteria outlined above, prospective investors should be able to effectively weigh the risks against the potential reward of superior returns and decide whether a particular fund of funds will complement their portfolio. Because of a lack of transparency and the depth of analysis necessary to make an informed evaluation of hedge fund of funds, many investors may find they don’t have the resources to effect a thorough assessment. It may be wise to engage the services of an investment professional experienced in evaluating this special asset class.

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Alternative investments involve risks that may not be suitable for all investors. When considering alternative investments, including hedge funds, you should consider various risks including the fact the some alternative investment products: often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as other registered products, often charge high fees, and in many cases the underlying investments are not transparent and are known only to the investment manager. Higher fees associated with alternative investments may offset any potential gains. Investors should consider the tax consequences, costs and fees associated with these products before investing.

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