Hedge Fund Due Diligence: A Step-by-Step Framework

Chapter 3 kicks off Part Two of the book, and this is where things get practical. We are done with the history lessons and strategy overviews. Now Travers rolls up his sleeves and shows us how to actually evaluate a hedge fund step by step.

He opens with an Einstein quote: “Not everything that counts can be counted, and not everything that can be counted counts.” Pretty fitting. Because hedge fund due diligence, as Travers puts it, is a mix of art and science. You need the numbers, but you also need judgment.

The Big Picture: What Goes Into Due Diligence

Travers lays out a circular diagram showing all the pieces that feed into a hire/fire decision for a hedge fund manager. But here’s the thing, he warns us right away that this is not a checklist. A lot of people fall into the “check the box” mentality, and that is one of the biggest mistakes you can make. You end up not seeing the forest for the trees.

So what are all these pieces? Here is the overview:

• Sourcing and Screening - finding hedge funds through databases, service providers, personal networks
• Quantitative Analysis - Sharpe ratio, downside deviation, alpha vs beta, correlation
• Fund Terms - liquidity, notice period, fees, sidepockets, gates
• Qualitative Analysis - the investment team’s skill, edge, pedigree, references
• Portfolio Analysis - exposure, attribution, long book vs short book, style drift
• Risk Analysis - factor analysis, stress testing, scenario analysis, skew and kurtosis
• Operational Analysis - independent valuation, independent administration, cash controls
• Financial Analysis - reviewing audited financial statements and expenses
• Legal Analysis - offering memorandums, compliance procedures, chief compliance officer
• References and Background Checks - checking with former colleagues, verifying data, background checks on key employees

That is a lot of ground to cover. Travers compares the whole process to a jigsaw puzzle where you have most but not all the pieces. Some people start at the corners and work inward, others start with one piece and work outward. Different approaches, same goal.

Where to Find Hedge Funds

Before you can evaluate a hedge fund, you need to find one. Travers covers three main sourcing channels.

Databases

There are about a dozen hedge fund database companies that collect monthly data from hedge funds. They let you filter by all sorts of criteria:

Qualitative stuff like firm location, fund strategy, inception date, redemption frequency, fees, lockup period, onshore vs offshore.

Performance stuff like annualized return, standard deviation, Sharpe ratio, drawdown, up/down capture.

Regression stuff like beta, alpha, and correlation.

Travers lists providers like BarclayHedge, Morningstar, Hedge Fund Research, Eurekahedge, Preqin, and others. These are the tools of the trade for anyone serious about hedge fund research.

Service Providers

Beyond databases, there are people who can point you toward interesting funds.

Prime brokers are a big one. They work closely with hedge funds on trading, operations, and risk, and they also run capital introduction services that connect hedge funds with investors. They host conferences, arrange meetings, and publish reports with useful data on hedge fund leverage levels, popular investment themes, and portfolio trends.

Auditors and accounting firms are another source, especially for smaller or newer hedge funds that need the most help getting noticed.

Software vendors and IT firms are less useful for finding funds directly, but they give you insight into the technology side of the business, which matters for operational due diligence.

Media and Google

Travers recommends spending time on financial news sites like Bloomberg, Seeking Alpha, ZeroHedge, CNBC, Wall Street Journal, and others. He reviews clips and articles daily.

He is a big fan of Google Alerts. He sets up automated alerts for names of key people at hedge funds he is invested in or reviewing, plus phrases like “new hedge fund launch.” One practical tip: if the portfolio manager’s name is something common like “John Smith,” combine it with the fund name, like “John Smith” + “Fictional Capital.” Otherwise you get hundreds of irrelevant alerts.

Putting It Together: A Mock Search

Here is where Travers makes it practical. He sets up a fictional search at a company called “Hedge Fund Analysis, Inc.” and walks through screening a database of roughly 9,000 hedge funds.

The filter criteria:

After applying all eight filters, the 9,000 funds shrink down to 35. But here’s the problem, 35 is still a lot. So the investment team adds a qualitative overlay:

• They eliminate funds where team members had previous bad experience with the managers
• They remove funds with wrong data in the database (this happens more than you would think)
• They drop funds that recently closed or will close before due diligence is done
• They cut funds too similar to ones they already own

After this qualitative pass, plus adding two funds that do not report to any database, they are left with five candidates.

Comparing the Five Finalists

Travers creates a summary report with performance stats, fees, and liquidity terms for each fund. Here is what stands out:

Fund One - Outperformed the S&P 500 over five years, but with the highest volatility of all five. Got hit hardest in 2008, bounced back hardest in 2009. Lowest fees (1% management, 20% performance) and best liquidity (monthly redemptions). One-year soft lock with 2% penalty.

Fund Two - Lowest returns of the group with middling volatility. Negative Sharpe ratio. The real red flag: down nearly 18% in 2011 while the S&P was up 1%. Standard 2/20 fee structure.

Fund Three - No negative years at all. Second best returns, lowest volatility, second highest Sharpe ratio. Smaller firm ($350 million) with higher fees.

Fund Four - Middle of the pack on everything. Small decline in 2006, moderate 2008 loss. Lower management fee (1.5%) but one-year soft lock.

Fund Five - Also no negative years. Best 2008 performance (up 8.2%), highest overall return, second lowest volatility, highest Sharpe ratio (0.43 vs Fund Three’s 0.41). Offers two fee options: pay higher fees and get better liquidity, or take a soft lock for lower fees. Smallest fund at $275 million.

What the Charts Tell Us

Travers also creates several comparison charts: risk/return scatter plots, cumulative return charts, rolling correlation, and up/down capture analysis.

The key findings:

• Funds Three and Five have similar return profiles
• Funds One and Two are highly correlated to the S&P 500 (meaning they are not adding much diversification value)
• Fund Three has the lowest correlation to the S&P, followed closely by Fund Five
• Fund One captured almost as much upside as the S&P but had the worst downside capture
• Fund Three had an incredible up/down ratio of 14x, meaning its cumulative up-market return was 14 times its down-market loss. Fund Five was next at 6x. The S&P was at 3.6x

The Winner (For Now)

Based on all this data, the team decides to start the detailed due diligence process with Fund Five. Why? Best risk-adjusted returns, strong up/down capture, and low correlation to the S&P 500 and to the other funds being reviewed.

But here’s the thing, this is just the starting point. The numbers got them to Fund Five, but numbers alone never make the final decision. The rest of the book will walk through every detail of evaluating this fund, from the first phone call to the final scoring model.

My Take

I like how Travers emphasizes that due diligence is not a checklist exercise. Too many people in finance treat it that way, go through the motions, check the boxes, and miss the big picture. His jigsaw puzzle metaphor is a good one.

The practical mock search is really useful too. Seeing how 9,000 funds get narrowed down to five gives you a feel for how the sausage is made. And the qualitative overlay step is important, because databases are full of errors and outdated information.

Travers wrote this around 2011-2012, so some specific databases and websites he mentions may have changed. But the framework? Still totally relevant.

Next chapter, we start collecting data on Fund Five.

Previous: Chapter 2: The Hedge Fund Asset Class Next: Chapter 4: Data Collection (Part 1)