Investing in alternative asset classes is a complex topic and is usually conducted through financial advisors. Investors directly communicate with hedge fund managers only if they are heavily involved with investing already or have a solid economic and business background. Both advisors and standalone investors should know basic questions to ask hedge fund managers before investing.
Questions can be grouped into several categories with a focus on investment strategy, performance and track record, risk management, fees, operations and transparency, liquidity, and exit strategy. While it will fall into the category of assumptions, talking about the future outlook can help an investor to grasp future plans and what can be expected in a specific period.
Since every one of these categories can include many crucial questions, in this article we will focus on the groups of questions. After finishing with the article, you will have a solid picture of what you should ask and know before you place your investment.
Key Takeaways
- Conducting due diligence and aligning your investment objectives with those of the fund is crucial before making an initial move.
- Discussing a set of predetermined questions with portfolio managers, you can do it yourself, or you can hire a financial advisor.
- Every aspect of the operations, from the investment process to the exit strategy, must be thoroughly scrutinized.
Investment Strategy
We do not want to label one question to be more important than the other, because all of these combined make a whole picture about a hedge fund and its operation. However, the first question should be in relation to its investment process.
Every hedge fund manager must be able to in-depth explain what the investment principles are that make their strategy a well-developed one and what sets them apart from the competition. Choosing an investment niche or a strategy is the line that draws the rest of the operations, like risk management, investment horizon, and liquidity.
Hedge funds can employ numerous strategies in their investment process, which makes them so potent in the marketplace. That also provides them enough ground to combine different approaches, making them unique in the crowded market.
Depending on the fund's preference, they could be looking at market insufficiencies impacted by global or local events, which can provide ample ground for investments. Macro and special situations hedge funds would look for that kind of opportunity. Funds that opt for finding the intrinsic value of the company and aim to capitalize on the company's revaluation by the market are something that characterizes value-oriented hedge funds.
These are just a couple of examples of investment strategies or niches that are out there. Based on the strategy the fund employs, the investor should already have some picture of how the rest of the process is handled, but discussion in detail is advised.
So in this group can fall questions like "What sets your investment philosophy apart from others?" "What are the criteria for your investment targets?" and "How do you adapt your investment approach when market conditions change?"
Performance and Track Record
While past performance is not a signal of things to come, knowing that you are investing in a fairly successful company is a good thing to start with. But do not disregard the rest of the inquiry process, because we witnessed hedge funds that were in one year at the top of their game, just to fall to the bottom in the next year.
When discussing this topic, keep in mind the investment horizon you are aiming at. Some hedge funds are intentionally betting on undervalued companies that need an interval of time to break out and make a positive impact. Others press for well-established companies that can practically guarantee a certain level of returns.
For this category are attributed these and similar questions. "What benchmark do you use to evaluate your performance?" "How does the fund perform during volatile market conditions and amid crisis?"
Risk Management
Risk comes with investing, especially in the complex alternative asset classes like hedge funds. Heavy reliance on leverage and risky strategies like special situations, distressed debt investing, or the infamous shorting are based on taking big risks. These strategies, if successful, can generate handsome returns, but if everything goes awry, it often pulls with it the entire invested capital.
That is why hedge funds employ multi-layered risk management operations. As a way to minimize losses, hedge funds place stop/loss orders, hedge their positions, and diversify their portfolios.
Some of the questions that are closely tied with combating risk are "How do you plan your risk management strategy?", "What are the limits to using leverage, and how do you use it in the investment process?", and "How are you protecting the portfolio against tail risks?"
Fees
Hedge funds have a two-component fee structure called 2 and 20, and it refers to 2% from assets under management and a 20% performance fee. Managers of most funds are earning significant sums, first from 2% of all AUM and 20% of outperforming investments. That pushes them to first attract more capital and second to take risks to generate excess gains.
Since these fees can take a solid chunk of investors gains, some hedge funds started changing this policy. Often they lower one component of the fee or, in some drastic changes, do not charge a management fee.
Investors started to notice these policy changes and are conducting due diligence in regards to fees and what is the best they can get for their money. The best and most direct approach is the best, so the question about the fee structure is more than enough.
Alignment With the Fund’s Goals
Hedge fund managers and CEOs can show the trust in their operations and alignment with their strategy goals by investing their capital in the fund. That can be a major trust signal that investors respect in a big way.
Before making your bets into a specific fund, you should inquire if executives and managers participate in the fund's assets under management. If the answer is yes, it is also good to know how they align their goals with the goals of investors.
Reporting Policies and Transparency
Depending on the fund, the reporting policy and transparency in operations differ. Some funds regularly, mostly quarterly, report in-depth to investors. On the other hand, funds with different levels of transparency and policies report annually, lacking in details.
While some investors do not pay much attention to these topics and are satisfied with solid and constant gains, most yearn to know how their capital is handled. Regular communication with investors develops trust, which, on the other hand, attracts new investors with fresh capital.
Questions that can shed light on this issue include something along the lines of these: "How regularly do you provide reports, and in what detail?" and "Do you share information about concentrated positions and illiquid investments?"
Liquidity
Liquidity of investments is one of the crucial talking points when choosing a hedge fund to invest in. Depending on the strategy, the liquidity can vary. Some funds prefer to invest in illiquid assets like debt instruments, real estate, private equity, or stocks traded in over-the-counter markets. When an asset is illiquid, or less liquid, it means that it can be difficult to sell it.
For an investor, that translates into longer and less frequent redemption periods when they can redeem their capital. Depending on the policy, hedge funds allow annual, quarterly, or monthly redemptions.
The overall liquidity of the portfolio also impacts the so-called lock-up period that is counted after the investor made an initial investment. Before the end of the lock-up period, redemptions are not possible, and it can vary between one and three years. There are examples of shorter and longer lock-up periods, but this is the most common timeline.
Important questions besides the obvious "How frequently can I attempt redemption?" and
"How long is the lock-up period?" The investor should also ask, "How does the use of leverage impact liquidity?" "What is the fund's plan in case of a sudden and large redemption request from investors?" and "What would happen in case the current management could not be able to continue leading the fund?"
Exit Strategy
Understanding the exit strategy is closely tied to the conditions under which the investor can redeem its capital. How many redemption days investors can have is also in correlation with the fund's strategy. Funds with less liquid strategies will offer redemptions on rarer occasions. On the other hand, funds dealing with highly liquid investments have a chance to exit from positions more easily, granting better redemption terms.
Redemption options can be roughly divided into three groups: hard lock-ups, soft lock-ups, and gates. Illiquid portfolios are employing hard lock-ups, translating into no redemption for at least a year. Soft lockups come with a redemption fee that is usually 2% or 3% of the redemption capital pulled from the fund.
Soft lock-ups are commonly combined with gates, which are used to limit the number of redemptions in one redemption day.
An exit strategy is one of the key characteristics for every investor, and important questions for a manager include, "What is the redemption frequency policy of your fund?" "In which situations does the fund use redemption gates to limit investors from taking back their investments?" "Are there penalties or fees for redemptions pulled before the agreed time frame?" and "In case the fund is liquidated, how do you manage redemption priorities between your investors?"
Future Outlook
While past performances can provide some comfort for a potential investor, a plan for the future is the factor that draws them in to place their capital. Without a proper plan for at least a couple of years, investing in a fund doesn't make much sense. Knowing what you can expect in terms of returns is essential for any financial planning, so discussing this issue with a hedge fund manager is crucial.
While the current state of the market, or trends, can make it look like the fund is doing great, managers should have a plan in case things take a different turn. This always happens, and it is the nature of the market.
Also, the competition is always evolving and trying to catch on. Keeping on to one's competitive advantages is a must, and managers need to know how to do it. Is it through attraction to top talent, new technology implementation, or differentiation strategies?
Some of the top questions for a hedge fund manager include "What is your 3 to 5-year plan?," "How will you adjust your strategy in case the market conditions make a specific turn?," "Are there plans for implementation of new strategies or investing in new geographies?," and "Does the fund discuss steps to building the resilience of the portfolio?"
