One of the most appealing aspects of alternative investments is that they’re alternative to the major broad-market indices, allowing investors to increase their diversification through reduced correlation to traditional asset classes. The flip-side of this attribute is that alternatives don’t really fit into a Morningstar “style box,” and this makes them difficult to evaluate against “similar” strategies – or to even determine which strategies are actually similar.
How should one compare and benchmark alternative funds? This is one of the questions explored in a new white paper by Steben & Company CIO John Dolfin and Senior Portfolio Manager Christopher Maxey. Titled “The Importance of Manager Selection within the Alternative Investments World,” the paper focuses on the role of fund of funds (“FoFs”) in selecting alternative investments, and it looks at how investors might conduct due diligence on their own.
The Role of Fund of Funds
“A quantitative comparison of alternative managers must be supplemented with solid qualitative due diligence and a diversified set of managers,” according to Messrs. Dolfin and Maxey. Historically, FoF firms have filled this role for many investors, as FoFs have the experience and scale to conduct proper due diligence and to provide appropriate manager diversification.
In order to provide investors with a “resilient return stream across a variety of different market environments,” FoFs must excel in two areas:
- Manager selection
- Portfolio construction
According to the paper’s authors, not all FoFs are equally proficient at both of these vitally important aspects of FoF management. Those that are, however, are certainly worth their fees, as they can help investors avoid “bad apple” hedge funds that take unacceptable risks or are “outright frauds.”
Three P’s of Due Diligence
Steben & Company advocates a “Three P” approach to due diligence and diversification:
- People: Background, education, philosophy, references, etc.;
- Process: Looking at both investment and risk management procedures; and
- Performance: Judging luck versus skill, making peer group comparisons, assessing risks taken, track record length, etc.
FoFs like Steben & Company have an advantage over individual investors in that they can move beyond database screening to extensive in-person interviews followed by a variety of other analyses designed to answer four questions:
- Can the manager be trusted?
- What sets this manager apart from others?
- Is the manager skillful enough to deliver actual alpha?
- Does the manager offer a “natural fit” within the overall portfolio?
Operational Due Diligence
Messrs. Dolfin and Maxey consider operational due diligence (“ODD”) a “second integral step” necessary to proper manager selection. “A manager may be smart and well-intentioned, but that manager can still suffer problematic valuation errors, regulatory penalties, or other outcomes that are distasteful to an investor due to the manager’s lackluster operational procedures,” the author’s write. ODD questions should probe the following areas:
- Quality of support personnel: COO, CFO, Chief Compliance Officer, Controller, etc.
- Systems and IT infrastructure
- Compensation structure and incentives
- Personnel stability
- Trading and operational processes
- Valuation and NAV accounting
- Interaction with service providers
- Legal, regulatory, and compliance issues
All of this can be a tall order for individual investors, and that’s one reason why FoFs are relied upon by many investors for manager selection and the due diligence tasks that come with it. Authors Dolfin and Maxey conclude their white paper by comparing FoF managers to expert auto mechanics – you might be able to select investments on your own or repair your car “DIY,” but most investors and drivers are probably better outsourcing the most specialized tasks to trusted experts.
For more information, download a pdf copy of the white paper.