Fund of Funds Due Diligence

Due Diligence for Fund of Funds Investing in Hedge Funds

The scandals and collapses in the financial industry has left many investors questioning the effectiveness of their due diligence practices. Managers and investors in the fund of funds industry certainly have reason to step back and reexamine their due diligence, as they discovered that they were not as insulated from the crisis as they had hoped. Fund of funds are intended to offer a greater level of diversification than investing in a single hedge fund but last year many fund of funds turned out to be just as vulnerable as traditional hedge funds.

According to Daniel Strachman and Richard Bookbinder, the authors of Fund of Funds Investing: A Roadmap to Portfolio Diversification, due diligence is not a failed practice, rather it is the solution. Many fund of funds simply followed the crowd toward the hot new hedge fund without fully understanding its strategy and how to diversify that portfolio investment. A great deal of this responsibility falls on the investors, say Strachman and Bookbinder.

...it's the responsibility of the investor to follow up and confirm whether or not those answers are true. This is not something that stops once the investment has been made; it is something that is ongoing and should be done continuously. Funds of funds get paid for post-investment monitoring and review.

The lesson we've learned is not that not all hedge funds are bad, not all funds of funds are evil, and not all separately managed accounts are negative. What we've learned is that we must do due diligence. ...because of the pace of growth in the industry and the pace of growth of those providing services to the industry, we think that due diligence has been lacking because people just did not feel they had to do the work.

Due diligence involves understanding how money is being managed, by whom, and who is checking on it to make sure the data are correct. It's about asking questions, getting answers, making sure the answers are understood, and making sure that what you see is really what you get.

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