Despite the additional quantitative metrics available for the analysis of risk, many of which were not even covered in this tutorial, qualitative risks are as important, if not more important, particularly when evaluating hedge funds. Since they are unregulated pools of funds and their strategies are more complex, it is imperative that a thorough analysis be completed on items other than numbers.
One of the most important evaluations is that of management. A fund must have good, strong management just like a company. A talented hedge fund manager with strong stock-picking abilities may perform well, but his contribution to success will be blunted if the fund is not managed properly.
The same could be said of back-office operations, including trading, compliance, administration, marketing, systems, etc. In many cases, a hedge fund will outsource many of the non-investment functions to third-party firms; we will cover some of these service providers later in the tutorial. Whether a fund has some of these functions in-house or if they are outsourced, they need to be at a level that allows for the effective functioning of the investment management process. For example, it is critical to have adequate systems to measure risks within a portfolio at any given time, so that the hedge fund manager can feel confident that his strategy is intact, throughout. It is also important for trading systems to be able to implement the hedge fund manager's ideas, so as to maximize the expected returns of the investments and to minimize trading costs that would otherwise harm returns.
Scale is another measure that is critical to a hedge fund's success and, although one might use quantifiable metrics to evaluate scale, it takes a subjective opinion to determine whether a fund's strategy will be impacted by having too large of a fund and by how much returns will be affected. Hedge fund managers often answer this question by providing both a soft-close limit and a hard-close limit to new funding, in addition to their opinion on how much they can actually manage and still be effective.
A soft close indicates that no additional investors will be allowed into the fund, while a hard close indicates that the fund will no longer accept any additional investments. A fund's capacity, for that matter, should then be higher than the level indicated for a hard close. Otherwise, it would imply that the fund will accept investments up until the point where they can no longer achieve the same returns with their stated strategy. An analyst should be cautious of a hedge fund manager that doesn't close at the time indicated, even if the manager states that he or she is finding opportunities in other areas that will allow for continued growth. In the latter case, you should be cautious of style drift and investigate whether the manager has any skills related to these "new opportunities."
When analyzing hedge funds, the important thing to remember is to look beyond the numbers and statistics. An investor can be lured into an inappropriate investment if the qualitative factors mentioned above are not analyzed within the context of the overall strategy. While there are some risks that should be unconditional, such as management integrity, there are others that can vary by hedge fund strategy.
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