Learning Outcomes
After reading this article, you will be able to explain the due diligence process for hedge funds and liquid alternatives, describe the main sources of operational risk, and evaluate how operational failings impact investment decisions. You will also recognize the importance of robust control frameworks and be able to outline best practice procedures for manager research required for the CFA Level 3 exam.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the processes and considerations involved in hedge fund and liquid alternative investment due diligence. Key areas from the syllabus include:
- Identifying operational risks unique to hedge fund and liquid alternative structures
- Assessing the manager selection process, including review of control environments and operational controls
- Explaining the role of operational due diligence in manager selection and ongoing monitoring
- Evaluating the impact of inadequate controls, transparency, or process failures on decision-making
These areas are exam-relevant and may appear in both item-set and constructed-response questions.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What distinguishes operational due diligence from investment due diligence when selecting hedge funds or liquid alternatives?
- Name three key operational risks specific to hedge fund structures.
- How might a failure in a fund’s control environment affect investor outcomes?
- Why is ongoing monitoring as important as pre-investment due diligence for alternative funds?
Introduction
Proper due diligence is central to successful hedge fund and liquid alternative investing. While investment risk is important, operational failures—such as poor controls, conflicts of interest, or weak administration—can result in rapid and significant losses, regardless of strategy. For the CFA Level 3 exam, candidates must address both initial and ongoing due diligence, considering not just investment performance, but the robustness of operating models and risk management.
Key Term: operational due diligence
The process of analyzing investment manager operations, controls, and business practices to identify risks unrelated to portfolio strategy.
Understanding Due Diligence in Hedge Funds and Liquid Alternatives
Due diligence for alternative funds extends well beyond traditional asset manager research. Investors must confirm the fund’s infrastructure is sound, checks and balances exist in fund administration, and that processes effectively mitigate risks of misuse of assets, errors, and fraud.
Why Operational Risk Is Greater in Alternatives
Unlike mutual funds, hedge funds and many liquid alternatives often lack independent board oversight, may use complex legal structures, and can employ higher use of debt or illiquid strategies. These factors increase operational risk and the potential for hidden failures.
Key Term: operational risk
The risk of loss due to failures in people, processes, systems, or external events—including fraud and control breakdowns.
To properly assess a hedge fund or liquid alternative, due diligence reviews must go beyond the portfolio to the people and systems operating behind it.
Key Elements of Operational Due Diligence
Control Environment Assessment
Effective due diligence involves targeted questioning and testing of a manager’s operational set-up, with specific attention to:
- Governance: Ownership structure, independence of oversight functions, and segregation of duties between investment, administration, compliance, and valuation functions.
- Fund administration: Use of reputable, independent third-party administrators, especially for valuation and cash controls.
- Custody arrangements: Assurance that fund assets are held with established, independent custodians.
- Trade processing and reconciliation: Strong processes for trade capture, allocation, and position reconciliation.
- Valuation policy: Procedures ensuring fair-value assessment of illiquid or complex securities.
- Compliance and regulatory oversight: Review of licenses, documented compliance programs, and regulatory actions, if any.
Key Term: segregation of duties
A control principle requiring separation of tasks among staff to prevent conflicts or errors from going undetected.Key Term: administrator
An independent service provider handling valuation, fund accounting, and often cash controls for investment funds.
Fraud and Misconduct Safeguards
Proper due diligence directly addresses risks of asset misappropriation or misstatement, including background checks on key personnel, verification of regulatory filings, and an understanding of disciplinary or legal history.
Transparency, Disclosure, and Reporting
Managers should provide:
- Clear, regular, and timely reporting of portfolio positions, risk metrics, and valuation practices
- Up-to-date offering documents, audited financials, and evidence of robust internal reporting lines
Ongoing Monitoring
Post-investment due diligence is not optional. Regular review and independent confirmations ensure changes in fund operations, ownership, or service provider arrangements are detected promptly.
Worked Example 1.1
A CFA candidate is asked to evaluate two hedge funds for operational risk. Fund A uses a respected third-party administrator, while Fund B’s portfolio manager handles all valuation, accounting, and investor reporting in-house. What issues should the candidate flag for Fund B?
Answer:
Fund B demonstrates a concentration of operational responsibilities with the manager, raising significant control risk. This lack of independent administration and segregation of duties increases the potential for both error and fraud. The CFA candidate should recommend further investigation and rate Fund B as high operational risk.
Operational Risks Unique to Hedge Funds and Liquid Alternatives
Common sources of operational risks in these funds include:
- Absence of independent valuation or NAV calculation
- Insufficient segregation between investment management and cash movements
- Dependence on a small key-person team or founder
- Conflicts of interest (side pockets, fee arrangements, affiliated transactions)
- Offshore legal structures that limit investor protections
- Limited transparency about fund holdings, financing, or use of debt
Worked Example 1.2
An alternative fund is found to keep all trading, reconciliation, administration, and valuation functions under the direct control of the chief investment officer. Name at least two operational risks present.
Answer:
There is a risk of undetected errors, misstatement of asset values, and the potential for fraud. Lack of segregation of duties and insufficient checks and balances are the primary risks.
Manager Selection and Due Diligence Process
A best-practice operational due diligence process includes:
- Initial data collection: Gather documents (offering documents, financial statements, organizational chart)
- Key-person interviews: Meet with COO, CFO, head of operations, and compliance staff
- Third-party verification: Confirm administrator, custodian, and auditor details independently
- Site visits: Inspect physical premises and IT infrastructure where needed
- Reference checks: Seek independent references for key personnel
After-Investment Monitoring
Even after investment, regular reviews are essential:
- Request updated financials, changes in service providers, and organizational announcements
- Monitor complaints, regulatory filings, and independent administrator statements
- Review investor reports and NAV calculation procedures
Exam Warning
Do not rely solely on published performance or glossy marketing documents. Always verify operational controls and independent oversight—failure to do so exposes investors to losses even if investment performance appears strong.
Operational Due Diligence and Liquid Alternatives
Liquid alternatives styled as mutual funds or UCITS funds are generally subject to stricter regulation, requirements for independent custody, daily NAV, and transparency. However, investors should still review the operating environment; conflicts, manager experience, and dependence on related service providers can still pose risks.
Summary Table: Common Operational Risks and Controls
| Risk Area | Potential Failure Point | Control or Mitigation |
|---|---|---|
| Asset valuation | Manager values hard-to-price assets | Independent administrator values |
| Cash movements | Manager has direct payment authority | Segregation, dual sign-off |
| Trade reconciliation | Back office not independent | Independent reconciliation |
| Fund asset custody | Affiliated or self-custody | Major bank or third-party custody |
| Frequent staff turnover | Key-person or control risk | Multiple, experienced operators |
| Service provider relationships | Frequent changes, poor-quality | Use of reputable firms, regular review |
Key Point Checklist
This article has covered the following key knowledge points:
- Operational due diligence is essential for hedge fund and liquid alternative selection
- Investors must assess the fund's control environment, administration, and custody arrangements
- Segregation of duties reduces risk of error and fraud
- Ongoing monitoring, not just pre-investment checks, is required for all alternative fund investments
- Operational failures can result in significant loss, even if investment strategy is sound
Key Terms and Concepts
- operational due diligence
- operational risk
- segregation of duties
- administrator