Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy

Brown, Stephen J.; Fraser, Thomas; Liang, Bing

doi:10.2139/ssrn.1016904

Cited by 63 publications

(36 citation statements)

References 23 publications

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“…Brown, Fraser, and Liang (2008) argued that effective due diligence is a source of hedge fund alpha. They found that large funds of funds (FoFs) can absorb the fixed costs associated with due diligence.…”

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Estimating Operational Risk for Hedge Funds: The ω-Score

Brown

Goetzmann

Liang

et al. 2009

Financial Analysts Journal

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Using a complete set of U.S. SEC filing information on hedge funds (Form ADV) The hedge fund industry, however, is also known for its high attrition rate. Selecting a successful manager can be very challenging. In a Capco Group white paper (Capco 2003), the authors estimated that half of all fund failures were caused by operational risk. The International Association of Financial Engineers has defined operational risk as the risk of "losses caused by problems with people, processes, technology, or external events." 2 These potential losses include the risks of failure in internal operational, control, and accounting systems; failure in the compliance and internal audit systems; and employee fraud and misconduct. For example, losses resulting from misrepresentation (e.g., Wood River Capital Management) and failures caused by management fraud (e.g., the Bayou Hedge Fund Group) can all be thought of as operational risk events.The increasing demand for hedge funds, together with potential failures as a result of operational risk, calls for due diligence in selecting highquality managers, which is commonly practiced by many prudent investors before they invest. Brown, Fraser, and Liang (2008) argued that effective due diligence is a source of hedge fund alpha. They found that large funds of funds (FoFs) can absorb the fixed costs associated with due diligence. The Alternative Investment Management Association has developed a comprehensive questionnaire for hedge fund due diligence, with detailed questions ranging from management and strategy to risk and service providers. 3 Because the assessment of operational risk necessarily relies on such intangible variables as historical manager behavior and unethical or illegal acts, due diligence in the hedge fund industry is primarily concerned with qualitative rather than quantitative matters. As the number of funds increases and the fixed cost of evaluating them remains constant, however, numerical scoring models similar to Altman's Z-score model (1968) for bankruptcy are needed. Although a quantitative model can never fully replace human judgment, the analysis of "soft information" can help prioritize the due-diligence process. Indeed, with the increasing flow of available information about managers, a reliable model that reduces the dimensionality of the due-diligence process is essential for assessing hedge fund exposure to operational risk.

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Estimating Operational Risk for Hedge Funds: The ω-Score

Brown

Goetzmann

Liang

et al. 2009

Financial Analysts Journal

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show abstract

“…In recent research, Brown, Fraser, and Liang (2007) argue that effective due diligence is a source for hedge funds alpha. They find that large funds of funds have the capability of absorbing the fixed costs associated with due diligence.…”

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Estimating Operational Risk for Hedge Funds: The ω-Score

et al. 2009

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“…As documented in the hedge fund literature, fund size, fee structure, and high watermark typically have important influence on hedge fund performance (see, e.g., Ackermann et al, 1999;Naik, 2000, 2004;Agarwal et al, 2009;Baquero et al, 2005;Brown et al, 1999Brown et al, , 2001Brown et al, , 2008Brunnermeier and Nagel, 2004;Cremers et al, 2005;Edwards and Caglayan, 2001;Getmansky et al, 2004;Liang, 1999Liang, , 2000. We control for these known effects in our empirical analyses.…”

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confidence: 99%