In 2013 I wrote two articles on hedge funds and managed futures (CTA) due diligence: Five Components of Hedge Fund Due Diligence and Five Components of Hedge Fund Due Diligence Part 2. The first article was viewed from the perspective of the investor or allocator’s and the second article was from the perspective of the CTA. This article will once again discuss the due diligence process from the investor’s or allocator’s perspective.
Below are five elementary ideas to keep in mind when performing due diligence on a hedge fund or CTA:
1) Audit trail of the due diligence process:The more organized and maintained the records are of the due diligence process on each manager, the better protected you are. There are two reasons for this:
a) In the event an investor asks for proof that due diligence was conducted, you have reports, evidence and data of the due diligence process.
b) If for some reason red flags or legal issues arise with the manager and their investors or with the regulators, you can prove that you actually performed due diligence on the manager. This became an issue for some firms claiming to have performed due diligence on Madoff, but in reality did not.
2) Account size tested for the portfolio: It is regular practice to ask the manager the minimum account size they will accept. However it should be followed up with, and especially for an emerging manger as to what account size was the portfolio tested with? If the manager states they tested the portfolio with a $1 million account, but they only need a $25 thousand investment to open an account, it begs the question of a logic gap and the need to understand if the performance would differ with a $25k investment. Will the $25k account get exposure to all of the markets in the portfolio?
3) Using NFA B.A.S.I.C. is basic: The National Futures Association (NFA) website has a database page called BASIC and lists all of the principals and APs registered with the NFA and if they had any regulatory violations in recent years. It should be one of the first exercises for due diligence. As “basic” of a task this may appear, I’ve come across enough cases where this easy to use tool has been under-utilized.
4) Any regulatory issues in previous positions?: During the background check of the principals have there been any previous regulatory violations when the person was employed at another firm? A great example of this was when some of my students for the graduate level managed futures course I teach at DePaul University, gave a presentation of a manager. Initially they said they liked the strategy of the CTA, however they dug deeper and found the principals previously owned a business regulated by the SEC and realized the firm had violated SEC regulations. They coupled this issue with a few other questionable items and stated there were enough red flags to stay away from this manager regardless of how much they liked the strategy.
5) Confirm, Confirm, Confirm!!! In real estate, it is all about location, location, location! In manager due diligence, it is all about confirm, confirm, confirm! Just because a manager tells you a fact, doesn’t mean it is true. You need to confirm the information as much as possible. It is better to have a negative surprise during the due diligence process then to have a negative surprise once you allocate to the manager.
This concludes my trilogy of due diligence articles. From time to time I will be writing more articles on the topic.
Copyright ©2014 Mark Shore. Contact the author for permission for republication at firstname.lastname@example.org
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.