Hedge Fund Analysis Introduction: Why Evaluating Hedge Funds Is So Hard

There are somewhere between 8,000 and 10,000 hedge funds out there. Let that sink in for a second. Even if you had infinite money, how would you figure out which ones are actually good?

That is the central problem Frank J. Travers lays out in the introduction to his book. And honestly, the more you think about it, the harder it gets.

The Questions Nobody Has Good Answers For

Travers starts with a list of questions that anyone evaluating hedge funds has to deal with:

• How do you filter 10,000 funds down to a manageable list?
• Why pick one manager over another?
• What factors should drive your hiring and firing decisions?
• How do you evaluate whether a portfolio manager actually has an edge?
• What questions should you ask hedge fund managers to really understand their skills?
• How do you measure risk accurately, and what info do you need from funds to monitor changes?
• What are the biggest mistakes people make when analyzing hedge funds?

Here’s the thing, these are not simple questions. Each one could be a book on its own. And to do proper hedge fund analysis, you need to cover investment strategy, back office operations, administration, legal, accounting, marketing, client service, transparency, reporting, and more.

It is a lot.

The Necker’s Cube Problem

Travers uses a clever analogy here. He brings up something called the Necker’s cube. It is a simple 3D drawing of a cube, named after Swiss crystallographer Louis Albert Necker who discovered it in 1832. The trick with this cube is that you can see it from two completely different perspectives, and both are correct.

So here’s what happened when I first saw this analogy: it clicked. When you are doing due diligence on a hedge fund, two analysts can look at the exact same data and come to opposite conclusions. Both can be right, depending on their perspective and framework.

This is why hedge fund analysis is described as a combination of art and science. You need a systematic process, but you also need judgment. The data alone will not give you the answer.

Why Travers Wrote This Book

The personal story here is actually interesting. Travers graduated from college in late 1989, thinking he knew a lot about finance. He started working at a fund of funds company as an analyst, bright-eyed and ready to conquer the world.

But here’s the problem: he quickly realized how little he actually knew. So he did the logical thing and went to the library to find books about manager due diligence.

There were none. Zero. He had to learn everything the hard way, on the job.

Fast forward a decade. Travers had climbed the ranks and became a portfolio manager at a fund of funds organization. One of his junior analysts asked him the same question he had asked years ago: “Do you know any good books about manager due diligence?”

Travers was sure somebody must have written something by then. He searched the internet. Still nothing. That was when he decided to write the books himself. He planned two: one for traditional (long-only) managers, and one for alternative investments like hedge funds.

The first book, “Investment Manager Analysis,” came out in 2004 through Wiley. He planned to write the hedge fund book right after, but life got in the way. Then 2008 happened. The market collapse exposed many hedge fund managers who had strayed from their stated strategies. And then Madoff’s massive fraud brought hedge fund due diligence into the spotlight.

That crisis basically proved why his book needed to exist.

What Makes This Book Different

Travers says that while many books have been written about hedge funds, none of them covered the complete start-to-finish process of due diligence. Most focused on one piece of the puzzle. His book aims to cover all five key components:

1. Operational due diligence - how the fund actually runs day to day
2. Risk management - how they measure and control risk
3. Investment analysis - evaluating the actual strategy and skill
4. Accounting and financial review - following the money
5. Legal analysis - contracts, structure, and regulatory compliance

Most books at the time focused heavily on investment analysis and maybe risk. Travers wanted to give practitioners the full picture.

How the Book Is Organized

The book splits into two parts.

Part One provides background: hedge fund history, growth of the industry, pros and cons of hedge fund investing, and how hedge funds fit into diversified institutional portfolios. This is context you need before you can start evaluating anything.

Part Two is where the practical work happens. It walks through a complete due diligence template:

• How to filter the hedge fund universe
• Initial information requests
• The initial interview process
• Performance analysis
• Investment and portfolio analysis
• Risk analysis
• Operational analysis
• Accounting and financial analysis
• Legal analysis
• Detailed face-to-face interviews
• A primer on interviewing skills
• Quantitative due diligence modeling
• Putting it all together

To make things concrete, Travers created a fictional hedge fund called “Fictional Capital Management” (FCM). Throughout Part Two, he takes you through each step of the process using FCM as the example. This is one of the best parts of the book. Instead of abstract theory, you get to see how each technique works on a realistic case study.

Practical, Not Academic

One thing I appreciate about Travers’s approach: he is upfront that this book is for practitioners, not academics. He assumes you already have basic comfort with global investing, financial instruments, and how markets work. He is not going to explain what a swap is or teach you Bayesian statistics from scratch.

Instead, the focus is on what matters in hedge fund analysis and how to process the massive amounts of information you get hit with every day to make sound investment decisions. That practical focus is what makes this book worth reading even years after it was published.

What’s Next

The introduction sets the stage nicely. Travers has a clear mission: give you a systematic, repeatable process for evaluating hedge funds. In the next post, we start with Chapter 1, where Travers goes into the history of hedge funds. It is actually a pretty wild story that starts way back in the 1940s.

Previous: Retelling Hedge Fund Analysis Next: Chapter 1: Hedge Fund History (Part 1)