Due diligence produces information about how assets can be expected to be managed in the future. It identifies the risks associated with the managers and strategies. Steps are taken to eliminate, neutralize, or contain those risks. A variety of important factors are identified and representations are made during the due diligence process prior to investment. They form the foundation upon which future investment activity and performance expectations are based. Funds or managers are in turn selected with reliance on these expectations. If the factors change, the basis for the future expectations, and thus the investment selection, no longer exists. Therefore, the ongoing due diligence process involves keeping up with the qualitative aspects of the manager or hedge fund as well as the quantifiable aspects of the investment portfolio. How investors monitor the risk and performance of any particular allocation is partly dependent on the type, quality, and timeliness of information available based on the degree of portfolio transparency.

Investors want to be assured that they are getting the exposure and type of investment that they believe the manager sold them. This is particularly important to those with fiduciary responsibilities for investing others’ assets. In reality, many managers tend to promote a more specific investment strategy than their funds actually pursue. Most investors are aware that blind faith creates a foolhardy investment strategy. Without transparency, they can determine actual risk exposure and risk-reward prospects only from secondary sources. As discussed in Chapter 15, prudent investing requires an investigation of the specifics of a fund manager’s investment strategy, past performance, and the risk controls used to achieve the fund’s returns. Based on this information, the investor constructs a set of future expectations for performance and risk parameters to which the manager must adhere. Parameters include use of leverage, types of instruments used, exposure to asset classes and sectors, number of positions, position size, amount of hedging, and frequency of trades. For each strategy, the investor should develop general parameters, and for each manager within that strategy there should be additional, more refined, parameters. Transparency ensures that the fund or the manager can be monitored for parameter compliance.

With transparency, the risk exposures of a hedge fund investment as well as a multiple fund or manager allocation can be monitored continuously by screening the portfolio on a daily basis for compliance with the parameters established during the initial due diligence process. This approach allows the investor to ensure conformity to investment guidelines. If a parameter is breached, the violation is detected, allowing it to be addressed immediately.

The portfolio is analyzed in three ways:

An exposure is a snapshot view of the portfolio’s contents. Exposures are analyzed to determine portfolio position concentrations, how many are long positions and how many are short, and how much leverage is being used. The second level analyzed is the relationship between the instruments: not just how much of the portfolio is long and how much short, but the relationship between the longs and the shorts. Are they matched pairs? Are they iterative constructions? Are the short positions hedges against the long? Against the market? Time series analysis examines time-dependent variables such as duration, time horizons of particular positions, and cyclical features. An example of this would be the average length of time a position is held in a risk arbitrage portfolio.

Investors use risk monitoring to confirm that each fund manager complies with the established risk parameters on a daily basis. For investors whose portfolios are allocated to more than a style manager, risk monitoring can be used to oversee the preset risk exposure of the multiple-manager composite. It allows investors to monitor whether their portfolio is diversified and risk exposure reduced, as would be expected when investment strategies are combined.

Technologies that allow for cost-effective risk management are now available, and these can be provided to investors who are afforded transparency by the managers with whom they invest. These include independent trade reconciliation, third-party pricing of the investment holdings, daily oversight of exposure limits, and active adherence to style management.

The following is a step-by-step illustration of how the risk-monitoring process works. The basis for this example is the methodologies and systems developed by and used at HFR Asset Management.

Independent pricing is absolutely necessary. Broker pricing is often inaccurate or incomplete. In many cases, the portfolio is priced by the manager. Obviously, there has to be an independent review. Prices should be confirmed for every instrument in the portfolio by using information provided by an independent pricing data source. Closing exchange rates should be obtained to convert any securities priced in non-dollar-denominated assets for purposes of risk analysis and portfolio valuation.

In the event that a current market price is not available for a particular security, the risk monitor should obtain market pricing information from third-party sources such as market makers, brokers, and dealers. Theoretically priced instruments such as collateralized mortgage obligations, swaps, and repurchase agreements are valued by using an industry standard model. Accrued interest can be calculated using standard calculation methods developed by the Securities Industry Association.

After the portfolio is priced, the performance for that portfolio is evaluated. Any significant up or down movement at the portfolio level is then investigated and documented. Performance across a group of managers with similar strategies is evaluated for outliers.

At the conclusion of the last trade day of each month, a final confirmation and validation of market price, quantity, and market value of each investment in the account is conducted. In addition, fees and fee accruals for each account are confirmed with each fund manager.

Each parameter violation is ranked according to severity levels custom-designed for the portfolio. All violations are listed on the daily guideline summary report, and the appropriate level is indicated

Three levels of review are required for all guideline exceptions. A portfolio risk analyst investigates each violation and provides comment and a recommended severity level. A senior risk team leader confirms each violation and severity ranking. Finally, a member of senior management reviews the complete guideline report on a daily basis.

In addition, risk modeling tools are employed to evaluate total portfolio risk under a variety of market scenarios. Position-level transparency allows for the inclusion of all assets in quantitative modeling tools that predict the reaction of each security to market shocks. These reports provide a perspective on macro-level risks for the portfolio using measures such as value at risk. Changes in responses to market scenarios and absolute predicted risk levels over time are investigated with the manager.

Regular, monthly qualitative evaluations for each manager are prepared, and any managers who are of concern are placed on a watch list for special attention and follow-up.