Hedge Fund Analysis

A detailed, step-by-step book covering the entire hedge fund evaluation process

Investing in hedge funds is different from investing in other asset classes. There is much less publicly available information about hedge funds performance than there is about mutual funds or individual stocks. Consequently, investing in this class requires more sophisticated investment knowledge, greater due diligence, and, in many cases, a better-developed ability to evaluate investment managers.

Hedge Fund Analysis provides a broad framework of how to approach this endeavor, from initial screening to analytical techniques, interviewing skills, and legal and contract negotiations. Along the way, it demonstrates a variety of mechanisms for monitoring and tracking hedge funds and the underlying hedge fund portfolios—explaining each stage of the process in minute detail and providing specific examples which fully explain the opportunities and challenges you'll face each step of the way.

• Provides a detailed look at how to source hedge funds, screen through them, and rank their strengths and weaknesses
• Lays out a thorough process for evaluating funds, from initial interviews to performance analysis to onsite meetings
• Reveals what questions to ask by strategy in order to understand the underlying risk factors associated with each
• Highlights non-investment analysis, including operational due diligence and risk management, as integral elements in the process

Written by a financial professional with over twenty years of experience conducting investment manager due diligence, this book will put you in a position to make more informed decisions when investing in hedge funds.

Introduction xi

PART ONE Background

CHAPTER 1 Hedge Fund History 3

So Who Invented the Hedge Fund? 4

The Samurai 4

The Academic 5

The Legend 14

The Innovator 17

CHAPTER 2 Hedge Fund Asset Class 29

Definition 29

Hedge Fund Structure 31

Hedge Fund Strategies 32

Advantages of Allocating to Hedge Funds 43

Hedge Fund Size and Age Impacts Performance 52

PART TWO Hedge Fund Due Diligence

CHAPTER 3 Due Diligence Process 57

Key Areas of Focus within Each Component of Due Diligence 57

The Due Diligence Process Highlighted in This Book 60

Putting It All Together 67

Some Initial Thoughts 70

CHAPTER 4 Initial Data Collection 77

Data Collection 78

Due Diligence Questionnaire (DDQ) 80

Fictional Capital Management 80

Other Materials 106

Further Analysis 108

13F Analysis 116

Hedge Fund Journal 119

CHAPTER 5 Initial Interview 121

Initial Call or Meeting 121

Phone Interviews 122

Meeting Notes 139

CHAPTER 6 Quantitative Analysis 145

Performance Measures 146

Absolute Return Measures 146

Absolute Risk Measures 154

Regression-Based Statistics 164

Peer Group Analysis 168

CHAPTER 7 Portfolio Analysis 173

Attribution Analysis 174

Fundamental Analysis 189

Evaluating Portfolio Data 193

CHAPTER 8 Onsite Interviews 217

Onsite Meeting Strategies 219

One-on-One Meetings 219

Meeting with More Than One Person 222

Different Perspectives 223

Meeting Notes 224

Onsite Interviews at Fictional Capital Management (FCM) 228

CHAPTER 9 Operational Due Diligence 259

Case Study: Bayou Fund 259

Definition 261

Importance of Operational Due Diligence 263

Categorization of Operational Due Diligence 267

Interview with FCM Operational Staff 301

CHAPTER 10 Risk Due Diligence 309

Graphical Depiction of Hedge Fund Risks 312

Risk Due Diligence 314

Factor Decomposition Analysis 330

Interview with FCM Risk Manager 333

CHAPTER 11 Reference and Background Checks 339

Onlist and Offlist References 340

Internet and Social Media 341

Contacting References 343

Problematic References 346

Whose References Should You Check? 349

How Many Reference Calls Are Enough? 350

Background Checks 352

Summary of Reference Calls for FCM 353

CHAPTER 12 Hedge Fund Scoring Model and Decision Making 357

Hedge Fund Scoring Model 358

Putting It All Together 374

About the Author 379

Index 381

FRANK J. TRAVERS, CFA, is a portfolio manager at Larch Lane Advisors. He has over two decades of experience analyzing traditional long-only, private equity, and hedge fund strategies. Previously, he was the director of research at First Peninsula Capital and a portfolio manager at Pine Street Advisors and CIC Group. Additionally, he held positions as the director of due diligence at CIBC World Markets, associate director of international equity research at Evaluation Associates, and senior analyst positions at Morgan Stanley Asset Management and RCB Trust. Travers is the author of Investment Manager Analysis: A Comprehensive Guide to Portfolio Selection, Monitoring, and Optimization, also published by Wiley. He received his BS in finance from St. John's University and his MBA from Fordham University.

With more than 8,000 hedge funds in existence today, the process of identifying, analyzing, allocating, and actively monitoring a short list of funds that meet your specific needs is harder than ever before.

While effective hedge fund analysis can be conducted in various ways and employ a myriad of models and techniques, the basic elements of the process are always the same. It requires answering essential questions that involve all aspects of the hedge fund business, including personnel, underlying investment strategy and risk, competitive advantages or "edge," back office and operations, administration, legal matters, financial issues, marketing, client service, transparency, liquidity, reporting, and more.

With over two decades of experience analyzing alternative and traditional investment strategies and managers, author Frank Travers knows what it takes to excel at this difficult endeavor. And now, with Hedge Fund Analysis, he shares his extensive insights with you.

Divided into two informative parts, this comprehensive resource provides background information—including the history of hedge funds, a discussion of their pros and cons, and how the asset class fits into diversified institutional portfolios—in Part One, and then moves on to detail a template for hedge fund due diligence in Part Two. To illustrate how the process works, Travers has created a fictional hedge fund organization and takes you through each step of the due diligence process, peeling back the onion one layer at a time so that you'll ultimately discover how to distill the massive amounts of information you're bombarded with and make informed and intelligent investment decisions. Throughout the book, you'll gain valuable insights on:

• Data collection and interviewing techniques
• Performance and strategy analysis
• Operational and risk assessments
• Legal and financial analysis
• Quantitative hedge fund scoring
• And much more

Created for the serious financial professional as well as anyone else looking to evaluate and understand how hedge funds work, this no-nonsense guide will put you in a better position to excel in this competitive arena.

With more than 8,000 hedge funds in existence today, the process of identifying, analyzing, allocating, and actively monitoring a short list of funds that meet your specific needs is harder than ever before.

While effective hedge fund analysis can be conducted in various ways and employ a myriad of models and techniques, the basic elements of the process are always the same. It requires answering essential questions that involve all aspects of the hedge fund business, including personnel, underlying investment strategy and risk, competitive advantages or "edge," back office and operations, administration, legal matters, financial issues, marketing, client service, transparency, liquidity, reporting, and more.

With over two decades of experience analyzing alternative and traditional investment strategies and managers, author Frank Travers knows what it takes to excel at this difficult endeavor. And now, with Hedge Fund Analysis, he shares his extensive insights with you.

Divided into two informative parts, this comprehensive resource provides background information—including the history of hedge funds, a discussion of their pros and cons, and how the asset class fits into diversified institutional portfolios—in Part One, and then moves on to detail a template for hedge fund due diligence in Part Two. To illustrate how the process works, Travers has created a fictional hedge fund organization and takes you through each step of the due diligence process, peeling back the onion one layer at a time so that you'll ultimately discover how to distill the massive amounts of information you're bombarded with and make informed and intelligent investment decisions. Throughout the book, you'll gain valuable insights on:

• Data collection and interviewing techniques
• Performance and strategy analysis
• Operational and risk assessments
• Legal and financial analysis
• Quantitative hedge fund scoring
• And much more

Created for the serious financial professional as well as anyone else looking to evaluate and understand how hedge funds work, this no-nonsense guide will put you in a better position to excel in this competitive arena.

"Starting from hedge funds's roots in Shogunate Japan, Frank Travers has written a truly comprehensive book on hedge fund analysis. Pulling from his years of experience as a hedge fund allocator, Travers offers insights that heretofore could only be learned on the job. With a colorful writing style and a robust sense of history, Hedge Fund Analysis is as interesting for the experience hedge fund professional as it is compelling for the novice. This book is a must read for anyone interested in hedge fund research."—Bruce MacDonald, Chief Investment Officer, Simple Alternatives

“As the title suggests, it is a no non-sense guide to the exercise of selecting hedge funds, that uses a sober and methodical language – among the few whimsical items are the fictional hedge fund organisation (FCM) and some dry quips.”—Opalesque