Below you’ll find a relatively simple list of the questions I always asked before my fund invested in any other funds. By simple I mean that they are useful even if you don’t have a graduate degree in mathematics, and not only that, reveal a great deal about any company, whether or not all the questions can be answered. Even a single red flag made me think twice. (These questions, of course, can be applied to almost any investment.)
1) Is there a free flow of information? How often, for instance is the fund’s Net Asset Value (NYSE:NAV) reported? Mutual funds report this number at the end of every trading day, and investors can find it in the newspaper or online. A good hedge fund will report its NAV at least once a month. Quarterly reports are important too. If any of these reports are late, a savvy investor will ask why.
2) Does the hedge fund have premier suppliers? These suppliers include: the fund’s prime broker (the firm that conducts its transactions, and provides leverage); the fund’s custodian (the firm that actually holds its assets); the fund’s accounting firm; and the fund’s legal firm. Are they all upper tier, reputable suppliers?
3) Does the fund have the ability to stay in the game? New hedge fund managers may not raise money as quickly as they’d hoped, or may adopt initial strategies that quickly bring the fund down because of a lack of capital.
4) Does the fund have a loyal investor base, and will its investors remain loyal when the going gets rough (because it always does, sooner or later). Look for sophisticated investors with significant assets; if the fund’s assets under management (AUM) are made up of new, hot money, and the fund has no lockup provisions—i.e., specific conditions under which assets can be redeemed—you should be worried.
5) Does the fund depend on a single stock picker, or is its success based on company-wide competence. Does the fund do its own research, or depend on numbers supplied to it?
6) Does the fund have a consistent approach? A good fund is focused, and doesn’t adopt a new investment approach every other week. Does the fund have a track record of at least three years? It takes time to get a style down and build a good staff, and investors should be wary of start-ups.
7) Does the fund have an exploitable niche, and if so, is that niche sustainable?
8) Where is the firm in its growth cycle? Most good funds start with an incubation period, followed by rapid returns, and then a leveling off. Look for a fund on the upswing. If you invest in a fund at the top of its arc, you’ve got to wonder whether the managers still have the same fire in their bellies they once did—before they made the big money.
9) Does the fund’s management have a good pedigree? Good fund managers come out of proprietary trading shops, where they learn how it’s done, and just as importantly, how to put controls in place.
10) How large are the fund’s assets under management (AUM)? Look for a fund with AUM that aren’t too small—indicating a lack of confidence—and not too big—which could lead to problems, depending on the investment style. And if the AUM is on the low side, can the management handle a suddenly increased asset inflow?
11) Do the fund’s managers have skin in the game? Put another way, do the fund’s managers eat their own cooking? If you feel pain, the fund’s managers should feel pain.
12) Does the fund’s office space demonstrate a long-term commitment to the business?
13) Do the fund managers have transparent, easily-monitored control functions in place (i.e., compliance, audit, risk management, etc.)? Is risk management embedded in the firm, and not just a police force working on the perimeter?
14) Are all of the fund managers, and all of the fund’s employees accessible? If you can’t get to them, there’s a good reason—that’s bad for you.
15) Does the fund have succession and business continuity planning in place? It’s one thing if power goes out to the whole city, and everybody’s down, and another entirely if only the offices of that particular fund lose power, their servers go down, or they don’t have multiple secure backups for their data.
16) Last but not least, does the fund’s investment strategy make sense? In addition, are its returns reasonable given the historical returns in that specific market environment?