Hedge Fund Due-Diligence: 1 Killer Question That Investors Rarely Ask

Nathan Anderson | September 8, 2015

strong ant hedge fund questionIt’s natural to focus on the ‘big questions’ when interviewing a manager, and one of the most popular requests is “Tell me about your BIGGEST position.” Upon hearing this request the manager usually responds with a beautifully rehearsed story about their highest conviction idea and why it’s the perfect opportunity.

I want to thank Tom Brakke of @researchpuzzler who brought to my attention a much better question which is likely to have a much larger impact: “Tell me about your SMALLEST position.”

The brilliance of this question is twofold:

1. The manager is unlikely to have a well-rehearsed answer and as a result you are more likely to get an honest answer.

2. It gets at the heart of the manager’s investment approach and their portfolio construction process. If it’s a long/short manager with 30 names in the portfolio, what is the incremental value of having the 30th in there? Is the manager trying to mitigate volatility? Or are they opening a ‘toe-hold’ position to see what happens?

As to the latter point, using a small position to ‘mitigate volatility’ is often a euphemism for adding fluff to a book and diluting the (allegedly) high-conviction ideas as a means of playing it safe. Similarly, as Tom points out, a toe-hold position is usually a euphemism for “I want to see if it goes up”. When managers take this approach they are willfully subjecting themselves to anchoring bias and simply playing momentum.

Investors need to understand whether a manager is truly building a portfolio of high-conviction best ideas or whether they are simply spreading the darts around and playing to their biases.

hedge fund due-diligence, hedge fund manager darts

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Nathan Anderson

Nate co-founded ClaritySpring and oversees the company's strategy and operations.

5 comments

  • Mike Bayer, CFP, CIM, FCSI - May 21, 2016 reply

    In light of the overwhelming academic evidence and historical data showing the extremely low probability of hedge fund managers to add any value in excess of their fees, the better question is why why investors (and especially the supposedly more sophisticated institutional investors) continue to ignore the evidence and pour money into hedge funds. Frankly I find this type of irrational and irresponsible decision-making reprehensible.

    Nathan Anderson - May 22, 2016 reply

    It depends on the manager and it depends on the investor’s ability to assess the strategies. Most managers do not out perform their fees but there are many that do and many who play an important diversifying role in a portfolio. To dismiss an entire industry that has most of the top investment management talent allocating across a multitude of unique strategies as “reprehensible” is extreme.

  • Bob Doviak - May 19, 2016 reply

    it is a very good point and I agree not many people asked that question.

  • Patrick Adrian - May 18, 2016 reply

    Great tip for any manager research professional! Thanks!

  • barry cohen - September 18, 2015 reply

    Private equity due diligence is worse.

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