Quantitative Due Diligence Print E-mail

Quantitative due diligence on hedge funds

Due diligence on hedge funds is, probably, the most contradictory area of alternative investments, because of difficulty in formalization, the private nature of hedge funds, and conflicting local legislation in different countries. Although institutions have been conducting due diligence for years, their routine procedures mainly focus on its qualitative side. The problem is not new as in 1999 the Federal Reserve Board stated that

The review team found that the due diligence and ongoing risk assessments of hedge funds were largely qualitative and lacked quantitative rigor.

Designed by seasoned hedge fund professionals yet enhanced by the most advanced hedge fund risk management frameworks, Quant due diligence methodology, backed by sophisticated quantitative due diligence software tools, is the most sophisticated one available today. It integrates both the qualitative and quantitative elements, thus delivering the competitive advantage to institutional investors and FoF practitioners.

Quant Due Diligence Process

Strategy Analysis

Usually hedge fund assessment ends at the trading strategy point due to non-transparency issues and unavailability of the underlying assets. Providing a deeper insight into the applicable trading strategies, Quant due diligence framework attempts analyzing strategy implied risks to the maximum possible extent:

  • Constructing the risk model of the applied strategy, if underlying assets are available
  • Finding the best closest strategy model delivering a similar risk/return profile
  • Identifying the strategy bottlenecks through rigorous testing and stochastic simulation
  • Comparing similar peer strategy performance

In fact, the strategy analysis phase often requires the same amount of quantitative research as the fund itself.

Integrated Quantitative & Qualitative Elements

A common argument against quantitative due diligence is that a pure data mining cannot provide the same investment insight as a deep qualitative assessment. Quant’s standpoint on this matter is simple: a robust due diligence system needs to incorporate both the constituent parts - qualitative and quantitative. Any bias prioritizing one part over another, would result in ignoring some risk groups.

Furthermore, the quantitative part should provide the additional information for the quantitative part and vice versa. For example, a sophisticated Style Analysis may reveal inconsistency in trading strategies, which, in turn, could expose purely qualitative issues with managers. On the other hand, qualitative due diligence typically takes much more time than quantitative; therefore, by deselecting managers based on quantitative tests first, we may greatly speed the entire process up.

Evaluated Risks

The quantitative phase of Quant due diligence includes evaluating the following investment risks:

  • Market risks
  • Credit risks
  • Concentration risks
  • Liquidity risks
  • Volatility risks
  • Style drift risks