Before investing in a hedge fund, it is recommended that investors ask certain crucial questions about the fund manager, investment strategy, and deal terms. For the purpose of this article, it is assumed that the investor meets the minimum eligibility requirements (ie: the investor is an accredited investor or qualified client).
Here are six questions investors should ask themselves before investing in a hedge fund.
1. Do I understand the risks?
As with any investment, it is essential to understand that returns are not guaranteed. An investor who is considering to invest in hedge funds is most likely well aware of the risks involved. There are different risk profiles for each fund; investments that have the highest potential returns are usually those that have the most risk. This all corresponds to an investor’s risk/return profile, or how much an investor is willing to risk losing to potentially reap outsized gains. Understanding that you may lose most or all of your investment is a key emotional and mental consideration. If you are prepared for this, you have taken the first step to prepare for investment in a hedge fund.
2. How are the fees structured?
Hedge fund fees can range from simple to complex. The standard fee structure is a 2/20 model, where the asset management fee is 2% and the carried interest, or performance fee, is 20% of investment profits. Fund structures can get more complicated. Investors should understand if there is a hurdle rate. What are the redemption terms? Subtleties in fee terms can mean significant difference in capital. In general, the more aligned the hedge fund terms are with the interests of its underlying investors, the better for each party.
3. How are the assets valued?
Hedge funds may hold assets that are illiquid. As a result, the underlying assets may be difficult to value since unlike stocks and bonds, they do not have a widely available daily opening and closing price. It is critical to understand that there is some gray area to valuation in funds that participate in illiquid assets.
4. Have I researched the manager and firm?
Investors should do extensive research on the fund manager and firm. Are there any SEC violations or pending infractions? A good resource is FINRA’s broker check for a quick search on the manager. Understanding the manager/firm’s track record is important. Is the fund an emerging manager with little track record, or an established industry veteran? There are pros and cons to both, but in general, emerging managers have a lot to prove, but can be nimble by having to answer to less stakeholders, and do not have the leverage to charge large management fees. An investor should completely understand the stakeholders involved, and should adjust their expectations accordingly.
5. Do I understand the strategic thesis of the fund?
Investors may not understand the algorithms behind a systematic trading hedge fund opportunity. However, they should have an understanding of how these funds generally behave. Leave the fund management to professionals and quant trading to computers. Your job as an investor is to be well informed and aware of the tendencies and trading characteristics that are inherently behind different hedge fund strategies.
6. Am I familiar with the due diligence process?
There is an industry standard due-diligence questionnaire provided by the Alternative Investment Management Association. Investors should read this over thoroughly. Additionally, they should vet the brokerage firm and other third party fund administrators that the hedge fund is working with in order to understand whether or not the fund is engaging with top-notch industry professionals. The manager should be willing to meet face-to-face, or to at least find some phone time to discuss track record, strategy, and how the fund is differentiated.
This only touches the surface of more detailed questions that should be asked related to specific due-diligence. The above should be qualified as a general roadmap to begin the initial investment discovery process. There is also no single correct formula for deciding on a hedge fund investment. With all of the new funds sprouting up, the very basics need to be understood before digging into the real question: is there a good case, given the managers’ knowledge and experience, that the investment will produce returns great enough to compensate for the potential risks?
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Sang H. Lee