Hedge Fund Benchmarking and Due Diligence Critical - Report

Stephen Harris

7 March 2006

The global hedge fund industry has demonstrated remarkable resilience in the face of a difficult market environment of low volatility and low risk premiums, according to a new report by US-based Mercer Investment Consulting. And to avoid getting caught out by fraudulent activities, investors are urged by Mercer to ask tough questions up front and to spend more time on operational due diligence. "By some accounts, up to 50 per cent of all hedge fund collapses are the result of operational failures, particularly misrepresentations, misappropriations of funds, and unauthorised trading,” said Jeff Gabrione, a Chicago-based senior consultant with Mercer. “Investors must be reminded of the important role that non-investment due diligence plays when selecting hedge funds and the need for them to fully integrate operational issues into the investment decision-making process." Non-investment due diligence involves examining accounting practices and valuation methods; legal structure, regulatory and compliance policies; trading, settlement, and execution procedures; human resource practices; implementation of technology; review of service providers; and management and governance practices. Mercer also stress the need for benchmarking managers after a year in which hedge fund returns overall seemed disappointing relative to past performance. "Over a three-year period, successful managers ought to attain their stated targets," said Mr Gabrione. "Peer comparisons are the next most effective means of benchmarking performance. Finally, investors can compare the hedge fund’s performance to an index for a rough gauge of opportunity cost, although we do not advocate it as the sole benchmarking metric. Ultimately, the decision to hire or retain a manager comes down to more than performance, but proper benchmarking makes the decision easier."