Hedge Fund Due Diligence

Most Hedge Fund scandals would be avoided with proper due diligence performed by experienced managers.


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April 19, 2012: Death of a great investment counselor, Carl H. Otto

Updated: April 20, 2012

Due Diligence case: A bond firm fits an overparametrised model.

Value added not from what the manager says.

I visited a Quant bond firm which had a few researchers modeling the bond market with a very complex model. None of the researchers had a Finance background, nor did they have a statistic/econometric background. A detailed analysis of their strategy showed that:

  • They were overfitting the yield curve, a yield curve that they never looked at the fit…
  • They were using an overparametrized model with over 150 parameters!
  • Since they did not know optimization, they were doing crude optimization by doing rough grid search on two to three parameters at a time, changing the parameters being searched every day.
  • The model was not using standard bond methodology including duration, convexity, or shift, twist, etc. Instead, they were using funny terminology not seen in any other bond firm, nor any bond book.
  • The leader was a good salesman who did not realized that the model was flawed.
  • Proper performance attribution showed that the model had an IC close to zero. Practically all the value added came from simply being long duration in a long period of declining interest rates.

Yet, this firm managed to convince numerous investors (over $1 Billion) to invest in such strategy. Shall I repeat that … as the president of one leading risk firm said, using complex mathematical processes does not make you a real Quant…?

Read “Marketing/Story telling organization vs Knowledge-based organization

For more information on proper statistical modelling methodology, please contact us.

Dominic Clermont, ASA, MBA, CFA

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