Morningstar Advisor - Spring 2007 - 25

investors do not have the resources and ability to perform such due diligence. For quantitative research, institutions and pension funds turn to either full-time in-house experts or outside consultants. They help institutions winnow down the list of appropriate investment candidates who meet the institution’s quantitative investment criteria. Then, once selections are made, these experts monitor all aspects of the institution’s outsidemanaged funds. They keep tabs on a variety of issues, ranging from style drift and exposures to various industries to concentration in individual securities and betas. This analysis is an important way to stay ahead of the curve by uncovering the red flags that often emerge before a fund encounters problems. It would be prohibitively expensive for an advisor to hire a consultant to do this type of work. Go without a consultant, and the advisor must have the expertise and the time to do the job solo. After selecting investment candidates, investors should dig deeper by finding out about a manager’s investment background and strategy, as well as the fund’s operations and risk controls. Meeting with a hedge fund manager personally is the best way to do that. In-house evaluations should encompass issues such as the true drivers of the fund’s fortunes (and, therefore, its risk factors), the fund’s competitive advantage and the sustainability thereof, the depth of the management team, the firm’s risk controls, insight into how the fund would react to various economic scenarios, management candidness, and other factors. In other words, all of the factors that an advisor would consider if he or she were going to acquire an ownership interest in a business should be answered adequately in this phase. Once again, advisors and individual investors get the short end of the stick here. Hedge funds can choose to talk to whomever they want, and they’re more likely to sit down to have an enlightening discussion with a large institution than with an accredited individual investor or an advisor with a few clients. 4. Side Letters Side With Clout In the mutual fund environment, all investors must be treated the same in all respects, including investment terms and fees. That’s not the case for hedge funds. Although a hedge fund’s offering memorandum details the terms by which the fund is sold, hedge funds can also issue side letters. Side letters can contain changes from the offering memorandum that are specific to the investor that is covered by the side letter. The letters can encompass any number of investment terms, such as fees, frequency of liquidity, and lockup. The guys who get side letters are those who have clout with hedge-fund managers— not most individuals and advisors. 5. Taxman Is Licking His Lips What to Ask a Hedge Fund Manager 1 When was your firm founded? What has been the evolution of the firm’s offerings? 2 How long have you been with the firm and what is your background? 3 What is the fund’s investment strategy? 4 What is your competitive advantage? 5 What trade or investment is emblematic of your style? 6 What are your key risk controls (concentration, stop-loss, volatility)? 7 Do you target your fund’s volatility? Most hedge fund managers, whose primary objective is to maximize pretax returns, employ high-turnover strategies. Tax considerations take a back seat. Arbitrage strategies, for example, which usually involve quick purchases and sales, are highly susceptible to punitive short-term capital-gains taxes. Not prioritizing tax considerations makes good sense for hedge funds—most of their investors don’t pay taxes. Pension funds, endowments, and individuals who are wealthy enough to set up offshore charitable trusts are able to invest in offshore hedge funds in order to avoid paying U.S. taxes. It is theoretically possible for U.S. investors to defer income taxes by investing in hedge funds through an IRA, but meeting the minimum initial investment requirement with an IRA and getting the hedge fund to accept an IRA investment are no easy tasks. Consequently, for the majority of U.S. individuals who invest in hedge funds, a fund’s pretax return (which is what it reports) will vastly outperform its after-tax return. Compounding this effect is the fact that even if investors don’t sell a stake in the fund, they are still responsible for coming up with the cash to pay their share of the fund’s yearly tax bill. 8 What is the biggest investment mistake you have made in managing the fund? 9 What drives your fund’s outperformance? (Follow-up questions are important here.) 10 What funds do you view as competitors? 11 At what asset size would you consider closing your fund? 12 To what extent does tax efficiency play a role in your investment decisions? MorningstarAdvisor.com 25

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Morningstar Advisor - Spring 2007

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