Operational Due Diligence and Manager Selection

Introduction

So, you’re thinking about investing in a hedge fund—or you’ve been asked to analyze one for your firm. You dig into the performance stats, read every footnote in the marketing materials, and check out recent press coverage. But is that enough? Hedging strategies and return streams may be exciting, yet the less glamorous side—operational due diligence (ODD)—is frequently just as crucial, if not more so. ODD focuses on the “plumbing” of a hedge fund: governance, compliance, service providers, and infrastructure. Ultimately, no matter how brilliant a manager’s strategy seems, weak operations can derail performance or lead to major losses.

In this section, we’ll unpack the operational aspects you need to evaluate when selecting a hedge fund manager. We’ll talk about the difference between investment due diligence (examining the strategy, philosophy, and performance) and operational due diligence (checking the mechanics and control environment). We’ll explore service provider independence, business continuity preparations, and that ever-important manager track record. We’ll also delve into frameworks for conducting interviews, scheduling on-site visits, and performing background checks. By the end of this article, you’ll hopefully feel more comfortable identifying the red flags that can lead to trouble, as well as the signs of a truly robust operational infrastructure.

Why Operational Due Diligence Matters

ODD is primarily aimed at mitigating “operational risk,” which the CFA Program defines as the risk arising from inadequate or failed internal processes, people, or systems. Historically, numerous hedge fund failures have traced directly to operational weakness rather than just poor investment decisions. Think about high-profile fraud cases: many of them were not obviously flagged through performance metrics alone. Instead, they were uncovered by suspicious operational details—such as missing documentation, unregistered auditors, or conflicts of interest among service providers.

Here’s a quick personal anecdote: I once visited the offices of a brand-new hedge fund manager who claimed to have a “state-of-the-art compliance desk.” When we arrived, the so-called “compliance desk” was one solitary person with a laptop that had very limited compliance software and about a million sticky notes with to-do’s. That’s not exactly the definition of “robust infrastructure.” The experience taught me (granted, the hard way) that we always have to verify claims through on-site inspections and not just rely on a deck of slides.

Given how easy it can be to misrepresent or even omit crucial facts, a well-structured ODD process is your best line of defense in picking the right hedge fund manager. Let’s discuss the key operational elements—governance, infrastructure, service providers, continuity plans, alignment of interests, and more—and break down why each of these is so vital.

Differentiating Investment Due Diligence from Operational Due Diligence

You may have heard the term “Due Diligence” (DD) applied in a broad sense. In hedge fund investing, we can typically parse it into two parallel processes:

• Investment due diligence: Focuses on the fund’s strategy, performance track record, risk-return profile, and how the manager generates alpha (excess return). This involves analyzing historical returns, factor exposures, portfolio composition, and the manager’s philosophy.
• Operational due diligence: Examines the non-investment aspects—like fund governance, systems infrastructure, data management, compliance, risk controls, and the independence and reputation of the fund’s service providers.

Some investors consider ODD as a “one-time” check. But in reality, operational due diligence must be continually updated. Markets and regulations change, teams and systems evolve, and business processes require ongoing scrutiny. The overarching goal is to answer a critical question: “Does this fund have the appropriate processes, controls, and people in place to operate safely and ethically, no matter the market environment?”

Key Components of Hedge Fund Operational Due Diligence

Fund Governance

Fund governance refers to the oversight structure guiding the hedge fund: board composition, management committees, and general oversight roles. Independent directors, for instance, play a vital role in representing the interests of external investors. They also help ensure the manager’s decisions adhere to the fund’s strategy and abide by regulations.

• Independence of Board Members: One major question is whether outside directors truly have “service provider independence” from the fund manager. Independence means they are free of conflicts of interest and can provide unbiased oversight. Look for board members who do not simultaneously serve in many other roles that could conflict.

• Robust Compliance Framework: Assess whether the hedge fund has a dedicated compliance officer who reports independently to the board or another high-level governance entity. Evaluate whether the compliance team is well-resourced and if there are clear documentation standards.

Operational Infrastructure

Operational infrastructure covers the middle- and back-office functions of the hedge fund, including trade reconciliation, settlement, cash management, and record-keeping. When operational infrastructure is subpar, errors can slip by unnoticed, or security measures may be insufficient to protect sensitive information.

A robust infrastructure typically includes:
• Reliable and scalable technology platforms for trade execution, portfolio management, and risk oversight.
• Proper document management and digital security (e.g., secure servers, encryption).
• Adequate staffing levels to handle complexities, such as a global trading strategy or multi-asset exposures.

Service Providers

It’s rare for a hedge fund to conduct all activities in-house. Managers usually rely on a network of external professionals including prime brokers, fund administrators, auditors, custody providers, and legal counsel. If these service providers are excellent and independent, the chance of conflicts of interest diminishes.

• Prime Broker: A prime broker is typically a large bank or securities firm providing services like trade clearance, custody, financing, and securities lending. Always confirm that the prime broker is reputable and financially sound.
• Fund Administrator: The fund administrator handles accounting, net asset value (NAV) calculations, and investor statements. It’s best if the fund administrator is recognized internationally and is free from any direct ownership by the manager.
• Auditor: The fund’s auditor must be a credible and reputable accounting firm. Check whether the auditor’s scope includes verifying the existence of assets, ensuring valuation methods are properly applied, etc.

Business Continuity and Disaster Recovery

What happens if a hurricane shuts down the hedge fund’s headquarters for a week? Or, if a critical server goes offline? A business continuity plan (BCP) should detail the fund’s procedures for dealing with major disruptions, whether natural disasters, cyberattacks, or server failures.

Similarly, a disaster recovery plan (DRP) typically focuses on the technological response—backup data centers, off-site data storage, and the speed with which the fund can restore normal operations. When evaluating a manager, request a copy of these plans and consider their realism. If the manager shrugs and says they’ll “figure it out when it happens,” that’s definitely not a good sign.

Manager Track Record and Alignment of Interests

We all care about the numbers—especially if the manager has delivered strong, consistent performance. However, track record extends beyond raw returns. It can show how returns have been generated under various market conditions. If the returns are suspiciously stable despite highly volatile markets, that might be a sign of manipulated valuations or reporting. For instance, if the fund invests in illiquid securities but rarely experiences large drawdowns, that’s worth exploring more deeply.

“Alignment of interest” is another critical concept. When a manager invests personal capital into the fund, they “eat their own cooking,” so to speak, which fosters trust among external investors. Conversely, if the manager has minimal personal skin in the game, it could signal a misalignment, where they might not feel the same level of risk or accountability.

Risk Control Philosophy

Does the manager have robust risk controls that extend beyond investment strategy? Often, large hedge funds have dedicated risk management teams that track multiple risk types—market, credit, liquidity, operational. Smaller funds might not have a dedicated risk officer, but they should still exhibit a disciplined risk culture.

On-Site Visits

A manager’s marketing materials can look stellar on paper or in a slideshow, but an in-person visit (sometimes referred to as an “on-site visit”) is crucial. This is the time to observe workflow, see the technology in action, and meet the team. Check the daily processes:
• How do they confirm trades with the broker?
• Where are documents stored?
• Do employees interact seamlessly, or is there disorganization that could lead to errors?
A short conversation with the back-office staff can reveal a world of insight about data management, vendor relations, and internal communication.

Background Checks

While it may feel a bit intrusive, background checks (legal, regulatory, and reputational) are a core element of ODD. You might discover prior legal issues, regulatory sanctions, or frequent changes in service providers. If a firm is constantly switching auditors, for example, that could be a serious red flag. Tools such as regulatory filings, litigation databases, and references from prior investors can all help you build a clearer picture of the manager’s reliability.

Service Provider Independence

Service provider independence refers to ensuring that third parties like administrators or auditors have no financial ties or conflicts of interest with the hedge fund manager. If, for example, your fund sees that the manager and the auditor share business ownership or have some kind of side arrangement, that’s obviously a red flag. In all normal cases, these service providers should remain distinct legal entities that don’t earn fees or additional benefits from the manager that could color their professional judgment.

Interview Framework and On-Site Visit Planning

Below is a helpful framework for structuring the manager selection process from an operational standpoint. Note that “investment due diligence” runs in parallel, but here we’re zeroing in on operational due diligence steps.

    graph LR
	
	    A["Initial ODD Screening"]
	    B["Documents, Policies,<br/>and Procedures Review"]
	    C["On-Site Visit"]
	    D["Service Provider<br/>Verification"]
	    E["Risk Assessment and<br/>Testing of Internal Controls"]
	    F["Legal and Regulatory<br/>Background Checks"]
	    G["Final ODD Report and<br/>Recommendations"]
	
	    A --> B
	    B --> C
	    C --> D
	    D --> E
	    E --> F
	    F --> G

A typical ODD starts with collecting basic materials—organizational charts, compliance policies, staff resumes, and so on. After a preliminary screening, an on-site visit is scheduled. The on-site visit is an excellent chance to see how everything works day-to-day. You then verify essential details with service providers (auditor, prime broker, fund administrator) to confirm that the relationships are legitimate and that statements from the manager match reality. Finally, you do a thorough background check on the manager and senior personnel. If all these steps turn up no “deal-killer” issues, you assemble a final ODD report with recommendations or conditions that the fund must meet prior to investment.

Common Pitfalls in Operational Due Diligence

• Relying solely on a manager’s self-reported data without independent verification.
• Neglecting to check references or do background checks.
• Not paying attention to suspicious or incomplete documentation.
• Failing to question frequent changes in prime brokers or auditors.
• Overlooking how service providers get compensated or whether they’re truly independent.
• Failing to note that real operational excellence is nuanced and goes beyond well-designed marketing materials.

Best Practices and Emerging Trends

• Continuous Monitoring: Thanks to technology, many investors now monitor their hedge fund’s operations on an ongoing basis. Tools exist that can pull trade data, compliance logs, and operational updates so that oversight is no longer a once-a-year exercise.
• Board Engagement: Some hedge funds now include investor representatives on advisory boards to ensure stronger alignment.
• Cybersecurity Focus: As digital threats expand, operational due diligence must now address server security, data encryption, and staff training on phishing or malware.
• Cross-Border Complexities: Global macro managers or other hedge funds with offices worldwide may face different regulatory regimes. Confirm that the manager is properly licensed and that infrastructure is consistent across regions. Consider cross-referencing Chapter 7 (Introduction to Digital Assets) if the hedge fund deals in digital tokens or crypto derivatives.

Brief Glossary

• Operational Risk: The risk arising from inadequate or failed internal processes, people, or systems.
• Due Diligence: A comprehensive appraisal of a business or individual prior to signing a contract, in order to establish its assets and liabilities and evaluate its commercial potential.
• Prime Broker: A bank or securities firm that provides clearance, custody, and financing services for hedge funds.
• Fund Administrator: An external entity providing accounting, NAV calculation, and investor reporting services to the hedge fund.
• Alignment of Interest: The degree to which fund managers invest their own money in the fund, indicating they share risks and rewards with external investors.
• On-Site Visit: A physical inspection of the manager’s office and internal operations, used to validate processes and claims.
• Service Provider Independence: Assurance that key entities like auditors and administrators have no conflicts of interest that compromise objectivity.
• Track Record: Historical performance data showcasing a manager’s investment skill and risk profile over time.

Practical Example: Case Study

Imagine you’re analyzing BlueRock Capital, a small hedge fund claiming to return 15% annually with minimal volatility. Their pitchbook is glossy, and the website is elegant. During your initial ODD screening, you request the following documents:

1. Organizational chart, detailing reporting lines and compliance responsibilities.
2. Copies of recent audited financial statements.
3. Proof of their relationships with prime broker XYZ Bank and an independent fund administrator.
4. Business continuity plan summary.

You discover that BlueRock switched prime brokers three times in two years. The official reason is “searching for better financing rates,” but that’s less convincing once you note that the prime brokers are also small or obscure. Additionally, the fund’s board of directors includes a longtime friend of the portfolio manager, and there’s no truly independent member.

Going on-site, you find that the “back-office team” is just one shared consultant who works part-time. Queries about the compliance manual are handled vaguely. The final straw is that the “administrator” is actually a small bookkeeping firm that’s never before administered a hedge fund. None of these points alone is an automatic rejection, but collectively they raise serious concerns about governance, risk controls, and operational stability. At this point, you would summarize your findings, highlight the operational red flags, and possibly decline an investment until these issues are addressed.

Final Exam Tips

• Use a Structured Approach: Examiners love scenario-based questions where a candidate must identify operational risks in a hypothetical hedge fund situation. Practice a structured approach, analyzing each operational area systematically.
• Memorize Key Red Flags: A test question might describe suspiciously stable returns or frequent auditor changes; be ready to call them out.
• Know the Glossary: Terms like “alignment of interest,” “operational risk,” and “independent directors” appear frequently in exam questions.
• Connect ODD to Ethics: CFA Institute’s Code and Standards emphasize the fiduciary duty to protect clients’ capital from both investment and operational risks. Expect potential questions linking ODD to the Code of Ethics.
• Time Management: On the essay portion, avoid over-explaining investment due diligence when the question specifically asks for operational considerations.

References

• Horwitz, R. A. “Investment Management Due Diligence: A Guide for Investors.” (Recommended for in-depth case studies on manager selection.)
• AIMA (Alternative Investment Management Association) “Operational Due Diligence Guides”:
https://www.aima.org/
• Scharfman, J. A. “Hedge Fund Operational Due Diligence: Understanding the Risks.”

Test Your Knowledge: Operational Due Diligence and Manager Selection