Unlocking Keys To Hedge Fund Failures

Date: Thursday, January 18, 2007
Author: Hedge Fund Daily

Due diligence can make or break a hedge fund, according to researchers at France’s EDHEC business school. In a paper titled Quantification of Hedge Fund Default Risk, which appeared in HFD sister publication Journal of Alternative Investments, authors Jean-Rene Giraud, Stephane Daul and Corentin Christory focus on the factors that failed funds have in common, and boiled it down to three lessons:

• "Thorough due diligence is an absolute requirements prior to investing" – the authors stated that some funds overdiversify, naively believing they need to include more than 40 funds. They conclude, however, that "an increased number of funds also implies less time to investigate each individual funds and the inclusion of funds with lower standards of operations, hence possibly increasing the final likelihood of default of individual funds."
• "The cost and complexity of hedge fund operational due diligence can be significantly reduced by performing an ‘informed’ due diligence process" – The authors said such a process will consider the relative important of the "main risk factors" to hedge funds in general, such as fraud, as well as the level of complexity/risk of the specific fund and management company it’s looking into. Admitting that they did not analyze all factors that come into play, the author do point to product complexity (investment style), geography and size as resulting different risk profiles.
• "An ‘informed’ diversification of the operational risk in the portfolio construction phase results in significant difference in risk-adjusted profiles."