The attractions of allocating a portion of a portfolio to hedge funds are well known; as an asset class, they have historically shown themselves to have provided excellent long-term returns uncorrelated with both equities and bonds. The most common vehicle used by private investors for hedge fund investment has been a fund of hedge funds (FOHF). FOHFs are usually unitized collective investment vehicles that invest in a range (often up to 60 or more) of individual single-manager hedge funds. The FOHF route can provide a high level of diversification and acceptable liquidity as well as the comfort of professional management. However, the increased public profile of individual hedge fund managers has increased interest in them, and many private client advisers are thus fielding enquiries on such managers as Icahn Enterprises L.P., Cerberus Capital Management, L.P., Odey Asset Management, Harbinger Capital Partners, Firebird Management LLC, and Paulson Investment Company.

As private investment vehicles, hedge funds make available only limited public information. Also, unlike most conventional (long-only) funds, they can opportunistically change investment strategy to suit their needs. For example, like their long-only equivalents, many equity long–short managers would be heavily (often 100 percent and above) net long invested into equities during equity bull markets, but unlike their long-only counterparts, they could dramatically and rapidly reduce this exposure (even going net short) if they thought the bull market was changing into a bear one.

Because the objectives of a conventional (long-only) fund are quite restrictive (for example, the prospectus of a U.S. equity fund often states that the fund must be effectively fully invested in U.S. equities at all times), it is possible for an adviser to predict with reasonable precision how the fund will perform compared with its benchmark. With hedge funds, no such precision is possible, and in view of the lack of public information and the opportunistic manner in which hedge funds are managed, firms that specialize in providing hedge fund advice dedicate tremendous resources to closely examining each fund prior to advising their clients to invest.

In this article, I discuss important areas in carrying out a hedge fund review that might otherwise be overlooked. Investment methodology and fund performance are certainly important factors to consider, but I will focus on other areas of concern that may be less obvious.

Administrator of the Fund and Its Role
In contrast to most U.S. domestic hedge funds, which use a partnership structure, most hedge funds elsewhere use a limited liability company structure. The fund (as a company) has a board of directors, auditor, memorandum of understanding, and articles of incorporation and contracts directly with other parties to provide the services that are needed to run the fund. The two most important are investment management and fund administration.

The role of the administrator is very important in a hedge fund review, and there are two particular things to consider. First is their identity. Although many small administrators do an excellent job, the reviewer will take comfort when he or she sees a well-known and large administrator appointed. Reasons for this preference include the deeper pockets they will often possess, the broader resources they have available, and the lesser influence that any other party related to the fund (such as the fund manager) will have over them.

Second, the extent of their role is important. It varies according to the terms of the contract under which they have been appointed by the fund and ideally should encompass the following:

• Holding physical custody of the fund assets (either directly or through control of the assets at the custodian or prime broker)
• Handling subscription and redemption monies and maintaining the share register
• Calculating the regular (usually monthly) fund net asset value (NAV) and performance figures using pricing sources and securities holdings reports that are independent of the fund manager and communicating these numbers to the investors

The depth of the relationship is such that the administrator often provides board members for the fund.

The stronger the administrator and the deeper its involvement with the fund, the more comfortable the adviser will be in recommending the administrator to its clients.

Regulator Overseeing the Fund Manager
Although the fund may be domiciled in an offshore location, such as Bermuda or the Cayman Islands, the actual investment management is usually carried out in one of the major onshore financial centers. For hedge funds, these centers are New York in the Americas, London in Europe, and Hong Kong, Singapore, Tokyo, and Sydney in Asia. All of these centers have strong financial regulators that are greatly experienced in the oversight of hedge funds, and advisers will take comfort when reviewing hedge funds managed in these locations.

Operational Infrastructure of the Fund Manager
It has been estimated that half of all hedge fund failures are derived from operational failures, so operational infrastructure is a topic of great interest.¹ A detailed discussion of potential operational risks is beyond the scope of this article, but two broad areas in particular are worth noting: lack of operations expertise and lack of capital.

Lack of operations expertise
When investment professionals (or teams) move from managing money within an institution (for example, the propriety trading desk in an investment bank or another hedge fund) to setting up their own investment management company, they lose the operational infrastructure that they previously relied on. Unfortunately, they often do not appreciate the contribution that this operational infrastructure has made to their success and do not adequately plan for its replacement. Consequently, on many occasions “star traders” have set up their own firms only to fail through lack of adequate information technology, compliance, trade support, personnel, investor relations, and all of the other operational support. These resources take time and money to construct and operate efficiently.

Lack of capital
A hedge fund manager requires a viable financial structure (an income to pay for its monthly costs and a capital cushion to survive hard times) as much as any other business. New “start up” managers often fail because they do not have sufficient AUM (assets under management) to produce enough income to meet their expenses, and their capital becomes exhausted. There is a race to raise enough AUM to become viable before the capital runs out, and even the most talented managers often fail at this stage. Although the level of AUM to manage a hedge fund viably will vary according to the investment strategy that it follows, a broad guide is that managers with less than US$100 million are vulnerable. An additional capital concern is the composition of the investors. A fund may have plenty of capital, but if it has one or two major investors or it is reliant on short-term money, it is still vulnerable. Ideally, a fund should have a diversified investor base of long-term and stable capital.

Personnel
The hedge fund manager and his or her team are crucial to the successful management of the fund, and it is thus important to find out whether they have the requisite skills and experience. Although the hedge fund industry has grown tremendously in the past decade, it still retains a “small world” feel, and it is usually possible to network within the industry to verify (or otherwise) the background of the manager and his or her team and to identify any gaps in their expertise.

Special Terms for Other Investors
The major concern here is that new investors may be discriminated against should there be a rush to redeem. This disparity often arises from one of two sources. First, large and important investors or early investors can negotiate better terms than smaller and subsequent investors. Second, the investment approach of the fund may change as it sees opportunities in less liquid markets. A good example is the trend of fixed-income hedge funds in providing private term loan finance to external businesses. This opportunity has arisen as banks have reduced their loan books because of the credit crunch. However, these investments are less liquid than the ones previously carried out by the hedge fund and can produce a liquidity mismatch between the underlying investments and the redemption terms given by the hedge fund to its investors. This mismatch can be rectified by allowing additional capital to enter the fund but with worse liquidity terms than the existing investors have. If the fund faces a high level of redemptions, these new investors may not be able to exit as they wish and can be left waiting for a considerable length of time.

Conclusion
Analyzing and selecting hedge funds is an intellectually and professionally rewarding niche. However, it is not an area for amateurs; advisers need to dedicate a lot of resources to doing it correctly.

Richard Boutland, CFA, specializes in the management of hedge fund portfolios in Hong Kong with EFG Bank.