Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy
Stephen J. Brown
New York University - Stern School of Business
Thomas L. Fraser
Attorney in New York City
University of Massachusetts Amherst - Department of Finance & Operations Management; China Academy of Financial Research (CAFR)
January 21, 2008
Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly - or fail - due to operational risk concerns. However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that we document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.
Number of Pages in PDF File: 21
Keywords: Hedge funds, operational risk, due diligence, alpha
JEL Classification: G1, G2
Date posted: September 30, 2007 ; Last revised: September 11, 2009
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