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Evaluating a hedge fund based on historical data is at best useless and at worst provides a false sense of security. 2. Asking a hedge fund to produce steady low-volatility returns will only lead to destruction of true alpha-producing strategies. 3. Bucketing hedge fund strategies by asset class and geographies does not provide correlation benefits and is not the way to evaluate hedge fund strategies. 4. The distinction between alpha and beta strategies is lost. A trader generates alpha, not the strategy. 5. Limiting an investment to 10 to 20 percent of a hedge fund manager’s total assets under management shows a lack of conviction in due diligence and a reliance on safety in numbers approach. 6. Funds of funds often do not know how to make the distinction between analysts, long-only managers, bookrunners, and proprietary traders. 7. To properly manage a hedge fund investment, fund of funds CIOs need to be experienced traders and trading managers themselves. 8. Throwing good capital after bad has turned the hedge fund industry to a house of second or even third chances. There should be little doubt left in the mind of the reader that given the current setup of the fund of funds industry and a lack of expertise, incidents like Bernie Madoff, KL Financial, Bayou Capital, Long Term Capital Management, Amaranth Advisors, etc. will continue to happen in the future as well. After the recent scandals, it will be disappointing if the funds of funds are permitted to hide behind a defense that many investors, some even more “sophisticated” than them, were fooled. It is quite evident that the funds of funds do not possess the requisite expertise and are following a flawed model to do their job. 2. Five Inviolable Commandments of Hedge Fund Investing (Excerpt from The Future of Hedge Fund Investing) Before we get into the proper way of conducting strategy-level due diligence, a hedge fund needs to have the following infrastructure in place before even the thought of an investment can be entertained. I call them the five inviolable commandments: 1. An independent industry-recognized auditor. 2. An independent industry-recognized administrator/custodian. 3. Trade execution via independent entities, like prime brokers. 4. Fund valuations conducted independently by a third party, like an administrator. 5. A hedge fund manager who is willing to talk at length and in depth about his strategy and provide regular risk and return reporting. The above ingredients will ensure the required transparency and veracity of the information coming out of a hedge fund. Once the above ingredients are in place, then begins the true due diligence, the strategy-level due diligence, by a fund of funds. 3. Ongoing Due Diligence: It Is Not Just About Returns (Excerpt from The Future of Hedge Fund Investing) As long as a hedge fund manager keeps posting positive returns, he will be left alone by the fund of funds investors. Most likely he will keep getting new capital inflows with little more than a cursory visit to the offices, so some more boxes can be checked on preprinted documents. As soon as the hedge fund manager enters a drawdown period, the questions start arising. If the drawdown is severe, a sense of panic starts to ensue and redemption notices start piling up. But as soon as the very same manager starts to perform well again, all is forgiven, and the same fund of funds starts lining up at the door to reinvest. Buying high and selling low is the mantra of the panic-struck investor. This is no way to conduct ongoing due diligence on a hedge fund investment. Returns are the result of a process; the due diligence should be performed on the process to make sure that the process is functioning as it should. If the process starts to break down, the investor should redeem his investment, and if the process is sound, the investor should stay committed, irrespective of the returns. A caveat to this statement is that the stop loss limits are not breached, as stop loss limits are an integral part of that process. Funds of funds provide the capital and pay the hedge fund manager fees. From a commercial standpoint, the funds of funds are the bosses, and the fund manager works for them. The funds of funds need to realize this and start acting like it. Ongoing due diligence should involve the following steps in terms of importance and a top-down approach: 1. The original five inviolable commandments, mentioned at the start of the chapter, are still in place that ensure the required transparency and veracity of the information coming out of a hedge fund. 2. Stated position, monthly, annual, and peak to trough drawdown limits are being followed. 3. The professional trading staff with the core competencies is still intact. 4. Risk reports need to be monitored on at least a weekly basis and any red flags, as shown earlier in the chapter from the hypothetical reports, need to be addressed with the fund manager. 5. Monthly telephone calls are made to go over the profit and loss attributions, market views, and positioning opportunities going forward. 6. The monthly telephone calls should be substituted with onsite visits every second or third month for face-to-face discussions. This opportunity should be used for discussions with some of the other trading staff as well to gauge the firm’s morale and other information about the company that would not be apparent in a telephone call. This visit should also be used to pick one or two of the recent winning and losing trades to dig deeply into what went right and what went wrong and, more important, why. Because the new fund of funds model will have a panel of experienced traders, they can also offer insight to the fund manager. 7. Keep the relationship professional; avoid due diligence over a game of golf or dinner and drinks. Sometimes the fund manager might become more relaxed in a setting outside the office, in which case let the fund manager do the drinking rather than the other way around.