What are Hedge Funds

   Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.
Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, who have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds.
This investor meets a number of managers and does conduct quite a bit of analytical review of the manager's strategy as well as returns. They will request data, historical returns, perhaps some portfolio information and run analysis or benchmark the fund via some software. All the information received comes from the manager and is taken at faith. They will meet with the manager for an hour and maybe track the fund prior to an investment. At some point they will send a 30-page questionnaire to the hedge fund manager to fill out. This questionnaire addresses a number of issues regarding the asset management firm, including having strategy specific, operational and risk management type questions. The problem in level two of course is the lack of verification of any information. All the information provided by the manager or the staff is supplied by the manager. A large number of investors fall into this category.
   Mutual funds, like hedge funds, are run by management companies. The traders, sales people and staff are part of the management company that actually runs the mutual fund. The biggest revenue generator for mutual funds are management fees and those fees are based on the asset base of the mutual fund. So in return for allowing these hedge fund managers to market time their mutual funds, the mutual funds received "sticky assets" or a large sum of money parked at the mutual fund where they would collect fees. All these hedge fund managers did was find those mutual fund management companies that would allow this type of deal and there you have the market timing scandal and late trading scandal. They also found broker dealers who will skate hedge fund prospectuses and rules to allow these hedge fund managers to market time mutual funds.
Hedge fund business is highly coveted in finance. Investment banks, attorneys, auditors and even the attorney general will do anything for these hedge fund managers due to their influence or more importantly their investor base and social circles.

   Another advantage of a thorough review of your hedge fund manager is that you can figure out how much of the costs are being passed through to the fund. It is not too hard to bury expenses in commissions and since your audited financial statements do not break out commissions you will never know about it. With willing broker dealers, hedge funds are easily able to pass on expenses to the fund via soft dollars or higher commission fees.

   Performing operational due diligence is not only about preventing yourself from investing with a fraudulent fund, it also allows you to protect yourself and differentiate funds that are passing through expenses to the fund or whether they are absorbing those fees themselves. It will also allow you to understand whether the proper infrastructure is in place for maximizing profits, idea generation, risk management and whether the systems and procedures in place can handle a particular capacity and can scale as the funds grow.