Because their operations are private and top managers enjoy celebrity-like status, hedge funds retain mysterious appeal to investors looking for an edge.

Why?

Traditional money managers and mutual funds are largely index-centric with little chance of delivering substantial outperformance, while hedge fund managers are perceived as Peter Lynch unleashed. That’s simply not true.

Relative to the market, most hedge funds have not been good investments. According to BarclayHedge, a major industry tracker, the average hedge fund has underperformed the S&P 500 six out of the last 10 years, including the past four calendar years.

Through the first half of this year, every hedge fund strategy substantially trailed the market, which was up nearly 14% through June. Even long equity bias funds underperformed the index by about 5%.

Throw in persistent reports of malfeasance, most recently headlined by longtime master of the universe Steve Cohen having his fund charged with insider trading, and most advisors may decide the waters are just too shark-infested to dive in. However, the biggest problem afflicting the industry of more than 8,000 funds is that too many are mediocre. Collectively, they have mired the value and perception of this independent form of asset management.

Potential Value
The case for hedge funds is that they can provide unique access to compelling, actively managed investment strategies such as distressed, event-driven, arbitrage, global macro and long-short debt or equity. And yes, there are seasoned managers who have shown they can consistently deliver gains without taking you on a roller coaster ride or needing to hide from the Justice Department.

For advisors who want to gain such exposure, the trick then is knowing how to first vet the hedge fund universe and then individual funds and managers to reduce the chance of getting clipped by a negative surprise and to increase the odds of boosting client returns.

Figure 1 will help you get started. It’s a primer of essential operational and investment issues you need to understand before committing a penny to a fund.
This review looks at four key categories: portfolio, management, risk control and transparency. The figure then identifies the underlying points each issue raises and the specific documents prepared by hedge funds that provide the answers. If they don’t, then avoid the fund. It’s that simple.

Start the search process by considering funds with at least $100 million in assets. Make sure this is investor assets or net asset value, not notional value, which includes leverage that could bump up the valuation several times. (Leverage exaggerates volatility. Advisors new to hedge funds should limit this multiple to three times NAV.)

According to Jonathan Kanterman, a hedge fund consultant, when a fund’s NAV is at least $100 million, it likely ensures use of quality service providers, hiring of dedicated risk managers and chief financial officers, and near-term sustainability.

Kent Clark, who oversees $20 billion as chief investment officer of hedge fund strategies at Goldman Sachs Asset Management, searches for compelling investment theses when considering strategies and sectors. “We had raised cash during the crisis,” recalls Clark, “and re-risked the portfolio post-crisis into, among other things, credit. Since then, we’ve moved away from directional credit into more trading and long-short credit strategies.”

To find the right managers, Clark reviews a very extensive list of characteristics, including “the investment team’s experience and expertise, alignment of investor and manager interests, thoughtful portfolio management, independent risk management with genuine input in the investment process, and clear evidence of qualified people, processes and systems.”

Red Flags
Knowing key red flags saves time, because when they are seen, it puts an immediate end to a fund review. Listed in Figure 3 are 10 such markers, ranging from management reluctance to clearly describe what they are doing, annual financials that are not audited and the inability to speak to one or two current investors.

One important red flag not mentioned is maximum drawdown: the percentage that a fund has fallen from a peak before fully recovering anytime in its history. There is no one standard level of drawdown because it can vary significantly by strategy and the age of the fund. But for conservative advisors, that limit should be no more than 25%, and recovery should not exceed six to nine months.

In addition, very small worst drawdowns are suspect, especially during times when you know the entire market has been slammed. If a number appears too good to be true, it probably is, reflecting suspect valuations or other financial engineering.

Many funds collapsed through this figure in 2008 because of illiquidity and forced selling (not necessarily loss of quality), which sent certain asset valuations plummeting. Some investors didn’t necessarily blame managers because of the universal meltdown going on at the time. And many who stayed on were rewarded as prices surged the following year.

Others, however, were not as fortunate when they saw their funds shut down. All funds will tell you they actively manage risk and will discuss metrics like VaR (value at risk) and speak about decisive daily management meetings to control the downside.

If wealth preservation is your main concern, then it’s advisable to find managers who—at a certain point—have shown to be willing to throttle back exposure and/or leverage to stop the bleeding. And those who claim they can do this will be able to explain the specific process and examples thereof.

In a recent study of 22 hedge fund failures, prepared by the nonprofit research and educational organization Greenwich Roundtable, the three most frequent causes (evident in half the cases) were excess leverage, liquidity problems and inadequate risk management. About a third of the time, key problems also involved inadequate transparency, unreasonable volatility and service providers.

One of the easiest ways to help avoid problematic funds is to visit management before investing. During such trips, Jonathan Kanterman has discovered gaps between what he reads in fund documents and what he sees involving staffing, technology, investment process and management spending time running other businesses. An on-site visit reveals something else that can’t be known from afar: If you aren’t treated like Warren Buffett, don’t invest.

Coda
Due diligence doesn’t stop once the investment is made. It’s only the beginning. Every year you should review key issues and remain satisfied with the answers. Flag deviations, and if they aren’t resolved, then seriously question your investment.

Goldman Sachs’ Clark says that when he sees “volatility larger than expected, it may suggest the manager is taking on more or different risk than we were told he would. And when we observe lower risk than expected, that may indicate inclusion of illiquidity and unmarked securities, or a manager deciding to focus on collecting management fees rather than trying to generate returns from performance fees.” 

For Clark, investors should never feel complacent. He believes “over the medium to long term, we don’t expect managers to consistently deliver strong returns and that fund rotation is an important part of achieving consistent long-term performance.”

Advisors can pass off due diligence by investing through institutional hedge fund platforms or funds of funds, with both approaches bringing added fiduciary protection. But this process will add another level of expense that may lead one to question whether the endeavor is worth it in the first place, because regardless of what industry pundits may say, hedge funds are not an essential part of any high-net-worth or institutional portfolio. Good managers are. And until you find one, don’t invest.