In this post, we continue with the journey that we began with Hedge Fund Analytics – Part 1.
Let us continue from the point where we we left off in the last post. In case you are looking for a historical perspective on hedge funds, you are welcome to read this post that I had written sometime back.
[perfectpullquote align=”right” color=”#16989D” ] Traditional asset allocation paradigm require adherence and covenants, while hedge fund strategies are typically opportunistic and organic.[/perfectpullquote]
Institutional investors have always understood and trusted the traditional asset allocation paradigm for long, but they realized that they had little to no experience dealing with absolute return strategies (read: hegde funds) . They then turned to intermediaries, viz., Fund-of-funds (FOFs), who professed to be hedge fund experts with extensive knowledge of the industry. They capitalized on investor apprehensions about seemingly opaque hedge fund strategies by creating diversified multi-manager strategy funds. Their objective was to create a way for hedge funds to fit into the established asset allocation paradigm with which institutions are comfortable.
[perfectpullquote align=”left” cite=”” link=”” color=”#16989D” ] FOF’s fund manager selection process is Tedious, often Biased, and Lacks External Validation[/perfectpullquote]
FOFs achieved success largely because they claimed to provide their investors access to “closed” and prestigious hedge funds. Investors typically would like as much “transparency” as possible about the way the hedge fund manager operates. The hedge fund manager on the other hand would resent such “disclosure” attempts. To solve this problem, FOFs would administer due diligence questionnaires designed to enhance the process of manager selection, evaluation, and monitoring. There were 2 problems with this approach:
- The due diligence questionnaires had 400+ questions and managers were required to answer them in writing, often once every quarter. This caused “response fatigue”, and often resulted in adhoc responses and worse, delegation to non-investment personnel who may not necessarily be informed about the business areas in question.
- The questionnaire is primarily a “self-assessment” tool where the manager is expected to “self-report” information about the fund. These answers may arguably be biased and investors have no way to validate the claims made by the fund managers.
Net-net, the information provided by FOFs about the underlying funds has not helped ease the investor anxiety about multi-dimensional risks associated with hedge fund strategies. This has created an opportunity for further intermediaries such as risk management vendors, and ratings agencies, to fill the void by adding due diligence services into their offerings.