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Emphasis on due diligence called key for hedge funds

Date: Wednesday, February 11, 2009
Author: Jeff Benjamin, Investment News.com

The new hedge fund reality places even greater emphasis on due diligence, but it doesn’t mean that investors should start ignoring or abandoning the alternative asset class.

This was part of the message presented to investors today at the Managed Funds Association conference in Key Biscayne, Fla., by Meredith Jones, managing director of PerTrac Financial Solutions LLC of New York.

“I think quantitative analysis tools are great, but without critical thinking skills, it’s just math,” she said. “Qualitative analysis is clearly more important than it’s ever been.”

Ms. Jones, who coordinates multiple levels of research for the Washington-based trade association, cited transparency as the key to understanding what a hedge fund manager is up to.

And the level of transparency expected of a manager is best established before you start investing, she said.

“You’re most powerful before you write that check,” Ms. Jones said. “Create a process for evaluating the information you get from the manager, because transparency is no good if you don’t know what to do with the information.”

As part of her presentation, which was geared toward rethinking the investment mandate, Ms. Jones said that now is a good time to define issues such as risk, minimum acceptable returns, liquidity requirements and strategy preferences.

“Also make sure to synthesize the information you get from the manager with what’s happening in the markets, and get enough information to make decisions and make sure it passes the ‘smell test,’” she said.

Consider, for example, basic peer group analysis.

“If one manager is significantly outperforming his peers, there’s got to be a reason for that,” Ms. Jones said.

She also poked some holes in general hedge fund industry estimates regarding market sizing.

“Anarchy” is how Ms. Jones described the way that multiple databases estimate the size of the industry.

Despite widely reported data estimating that there are about 9,000 hedge funds, she said that her research, which includes compiling information from a dozen databases, suggests that there are 18,200 hedge funds.

According to Ms. Jones’ research, 1,400 funds were added last year, and 5,620 funds stopped reporting to databases.

Using a 5,500-fund sample, she calculated that the average hedge fund lost 13.6% last year.

This compares with a 37% loss for the Standard & Poor’s 500 stock index and a 40% drop for the MSCI World Equity Index.

“That shows significant alpha,” Ms. Jones said.

Individual hedge fund returns last year ranged from a 140% gain to a 100% loss.

Top-performing categories were managed futures, long-short equity and macro.

“You can see it’s not a homogenous group, and that opportunities do exist,” Ms. Jones said.