Performance and story-telling - A good due diligence combination

One of the most perplexing and important issues for any hedge fund investor is manager due diligence. Investors have gotten very good at operational due diligence in the post-Madoff era, but the same cannot always be said about skill assessment or investment process due diligence. 

There is no doubt the quality of skill assessment has improved over the last few years. The ascent of factor-based analysis has done a good job of better describing the risks taken by managers. Skill assessment has also done a better job of separating alpha from beta for many hedge fund styles. Still, more work is needed in this area. There is still too much reliance on performance screens versus an assessment of a manager's ability that forward-looking.

We think a simple two approach can be helpful. While many investors implicitly do this analysis, it is not structured within the due diligence analysis.  The two step approach is to to look at performance and the story that is told around performance. We believe the power of story-telling or describing the investment management process has the power to explain. This power of explanation is critical in being able to differentiate skill from luck. 

We will provide more detail on what is required for good investment story-telling but our simple matrix can describe our two-step approach. Good performance with a good story will show skill. Positive performance with a poor story concerning the investment process signifies luck. Similarly, negative performance with a good story would suggest an unlucky manager. A negative story with poor performance may suggest limited talent. 

Good story-telling may be viewed as just good marketing; however, it can be much deeper if the due diligence is conducted properly. The critical issue for due diligence is determining whether screened performance for a specific period of say three years is a true indicator of future performance. There is little doubt that skilled managers will perform well, but it is unclear over what horizon or whether recent behavior will carry-over in a different environment. This is why the qualitative story is critical. Story-telling about how investments are made, risk is assessed, and models built is a differentiator for picking managers.