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Pinpoint the themes and questions that an investor might weigh when assessing a hedge fund manager.

FRM® Part II · Risk Management and Investment Management · Performing Due Diligence on Specific Managers and Funds · FRM2.IM.12.c

The idea

When assessing the manager as a person and a business, the investor asks a set of recurring questions. Who are the principals, what is their experience and track record, and is the team stable with a succession plan for key people? What is the edge? Why should this strategy earn a return, why does it persist, and how much capital can it absorb before the edge fades? Is the investment process disciplined, covering idea generation, position sizing, entry and exit rules and handling of losers? Does the track record come from the stated process, and how did the fund behave in stress? Are incentives aligned, through the manager's own capital, fee terms such as a high-water mark, and liquidity terms? The exam point is that returns must be explained by a repeatable process, not simply observed.

A practice question

From the question bank, with the reason each wrong option is wrong.

A manager has invested a substantial part of personal wealth in the fund alongside investors. How should an investor interpret this?

  1. As evidence that the fund's risk is low because the manager would not invest otherwiseWhy not: Confuses alignment with low risk; large personal stakes can accompany risky strategies.
  2. As evidence of alignment of interests, since the manager shares in the fund's losses - correct
  3. As a negative sign because it concentrates the manager's wealthWhy not: Reverses the signal; investors generally view manager co-investment positively.
  4. As irrelevant because only the performance fee drives incentivesWhy not: Ignores that personal capital changes the payoff by exposing the manager to losses.

Co-investment aligns incentives because the manager bears losses as well as collecting fees. It does not guarantee low risk, but it is a positive indicator.

A harder one

A manager's three-year record shows an annual return of 18%, but most of the gain came from one large short position in a single month. What is the most appropriate conclusion in due diligence?

  1. Repeatability is uncertain, so the investor should ask for return attribution - correct
  2. The record is strong enough to confirm skill because the average return is highWhy not: Treats the average return as evidence of skill without examining where it came from.
  3. The record should be ignored because three years is too short to analyseWhy not: Ignoring all the evidence is not diligence; the investor should explore the sources and consistency.
  4. The short position proves the manager's process is soundWhy not: One outcome, even a large one, does not demonstrate a repeatable process.

Attribution shows whether returns arise from a repeatable process or from a single event. Dependence on one trade weakens the case that the edge is persistent.

The hardest tier

A manager says the fund is market neutral. Which finding is most inconsistent with that claim?

  1. Gross exposure averages 200% of NAV, with long and short books of similar sizeWhy not: High gross exposure with matched long and short books is consistent with market neutrality; net exposure is what matters.
  2. The return distribution shows a small negative skewWhy not: Skew is a feature of the return shape and does not by itself indicate directional equity exposure.
  3. A regression on an equity index shows a significant beta of about 0.7 - correct
  4. Portfolio turnover is high, with positions typically held for a few weeksWhy not: Holding periods say nothing about market exposure.

Market neutral means near-zero net market exposure, so a significant equity beta contradicts the claim. Gross leverage, turnover and skew can all coexist with neutrality.

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