Quantitative vs. Qualitative Print E-mail
Although institutions have been conducting due diligence for years, their routine procedures mainly focus on its qualitative side. Thus, the main drawback of the commonly used due diligence frameworks is a lack of its quantitative component. Conducted blindly and formally based on filling pre-designed questionnaires, such due diligence process is largely worthless, because doesn't provide a deep analysis of fund performance and risk management. This hurdle is not new - even the Federal Reserve Board stated in 1999:
The due diligence and ongoing risk assessments of hedge funds were largely qualitative and lacked quantitative rigor.
On the other hand, relying primarily on a quantitative assessment methodology presents another extreme bias also leading to likely misleading and questionable results. The quantitative evaluation of hedge funds involves a number of serious arguments that need to be addressed properly:
  • low consistency of data leads to questionable results of any calculations whatever models are used
  • non-transparency of hedge funds implies difficulties of measuring risks as the underlying assets are not disclosed
  • short data series cannot provide statistical significance of calculations, thus making statistical analysis problematic
  • past performance is a weak indicator of future returns
  • non-normality of hedge fund distributions of returns makes the commonly used mean-variance theory inapplicable
We have been witnessing endless arguments and discussions of a right balance between quantitative and qualitative due diligence approaches for years. Our standpoint on that matter could be summarized as follows:
  • there is no point to discuss a balance between these two due diligence parts. Due diligence on hedge funds should access all the applicable risks, while risks could be evaluated either quantitatively or qualitatively
  • the accessed risks should include: market, credit, liquidity, volatility, operational, currency, legal, fraud, concentration and strategy risks
  • the conventional Markowitz mean-variance methodology is hardly applicable to hedge fund evaluation and, as such, should not be used. The applied frameworks should address numerous peculiarities of hedge funds: non-normal distributions of returns, index biases, low correlation with their indices, and limited return series