Due Diligence as a Source of Alpha

Christopher M Schelling

Manager due diligence is fundamentally the process of researching and evaluating the performance and abilities of an investment management firm. For institutional allocators that outsource asset management to external investment managers, it is arguably the most important investment process outside of the asset allocation decision. While manager due diligence is certainly employed across all asset classes, including traditional equity and fixed income portfolios, it bears more relevance to the selection of alternative investment managers, including currency managers, given the different types of risk and wider dispersion of manager returns inherent in these strategies.

For instance, an investment in a hedge fund often results in not only larger tail risks than would be otherwise expected given the closer to lognormal return distributions usually found in traditional investments, but also additional qualitative risks such as limited transparency, moderately to significantly reduced liquidity and, ultimately, delegation of custody of the assets. Further, the broad mandates and high fee structures in alternatives give rise to the potential for managers to take undue risks, or even