Risk Management and Due Diligence for Alternative Investments

Due diligence for hedge fund selection includes looking at the track record (if any), investment strategies, redemption rules, and many other qualitative and quantitative factors.

Private equity funds require investors to look at the track record. The investment horizon is equally an important consideration. In addition, a careful review of the investment redemption and payback rules is crucial. Due diligence in real estate means good property management (often through dedicated firms) and a careful assessment of the market forces relevant to the property.

In any case, alternative investments often rely heavily on managers to execute a good strategy. Bad management practices can often go unnoticed in the volatile and translucent markets of alternative investments.  Independent valuation and proper guidelines for investments can provide a buffer against losses. Proper due diligence includes a look at operations, executives, organization, portfolio management, accounting controls, risk management, legal review, contract terms, and a host of other factors.

Alternative investments form a part of a portfolio for a savvy investor. They, however, ought to always fit within a broader portfolio. These investments offer an invester a chance to get more performance and lower risk. Even then, a degree of caution is warranted.

Asymmetric risk and return profiles, along with limited liquidity, low information, and regulatory/governance complexity, are hurdles for investors. In addition, these securities often have counterparty risk, liquidity risk, compliance issues, and difficult forecasting potential.  However, they offer a savvy investor a chance to balance their portfolio and seek higher returns with lower risk if used correctly.

Question

Which of the following are least likely risk management issues for alternative investments?

1. Asymmetric risk and returns
2. Reliance on expert management skills
3. Lack of diversification benefits

Solution

The correct answer is C.

Diversification benefits are a key selling point of the alternative investment market.  These investment are marked by volatile returns and the need for savvy management.  Reasonable fund terms are crucial to an investor’s individual financial needs (redemption, fee structure, holding period, etc.)

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describe risk management of alternative investments