Hedge Fund Research Best Practices

Being an analyst at a hedge fund is no mean feat. You’re responsible for taking ideas (possibly coming up with them as well) and coming up with quality research/models that can justify building an investment thesis out of it, that someone else (possibly you) will execute on. This can be a tough job, especially when the trade blows up the investor’s face, or when the research is found to be lacking in one (or more) aspects.

It’s important, therefore, to be aware of how your research and analysis aligns with some elements of the fund/firm before even beginning:

Alignment with Portfolio/Fund Construction

This should be the most obvious and clearest one. If you work at a fund with a highly liquid long/short strategy, pitching a real estate or private equity idea might not be the best use of your time. It’s important to understand that when raising capital, your fund manager agreed on certain provisions, that include the investment process itself but also matters like liquidity.

An idea — and research elaborating on that idea — that goes against that investment process and liquidity goals, for example, is not only style drift per se, but if it represents a sizable allocation of the fund, it can create IR problems and threaten possible future allocations.

Ideas that are not aligned with portfolio/fund construction can be pitched exceptionally, but usually only if they seem like a sure thing, and even then vetted by risk management/compliance and fund direction.

Alignment with Portfolio/Fund Expectations and Requirements

Many fund managers are not clear about what their expectations are for trades. Risk/ratio profile, allocation sizes and other concrete elements. This causes traders to execute improperly, not according to portfolio/fund requirements, because they’re not even aware what they are in the first place.

This affects hedge fund research and idea generation in some cases. Although usually research only dictates the play in general terms, while it’s the actual trader/PM that defines the concrete execution steps, like the risk/reward profile, knowing the fund/portfolio expectations can never hurt.

If you know, for example, that the risk/reward profile immediately eliminates certain stocks from consideration in a long/short portfolio, then that also tells you which other ones are great ideas.

Alignment with Risk Management & Compliance

There is some level of correlation between this point and the previous one, but it merits mentioning on its own. While the CIO/fund manager should know specifically what are the expectations in terms of risk management, for more institutionalized funds there will be a specific person or department managing these. It’s important that any idea obeys these, naturally.

Just like with the previous point, although risk management usually affects an investment when it’s already post-research and in the actual investment thesis stage, defining execution parameters, knowing risk guidelines can shape some ideas and kill others.

Research Model/Process Consistency

For any hedge fund, but even more for those pursuing institutional-quality operations, processes are key. Process, process, process. Doing excellent research is not a matter of one brilliant analyst performing one specific analysis, it’s a matter of having a process, checklists, guidelines so that quality of analysis can be replicated for other subsequent investment ideas.

In good firms, analysts and traders get together to talk about what are good research guidelines. A good idea is to take the cases of the best trades/best analyses and reverse-engineer research made on them. Guidelines can be extracted from them to create a general model.

At the end of the day, it’s not about the quality of this piece of research. It’s about the quality of the replicable process for all future hedge fund research.

Collaboration with Traders/PMs

Since traders/PMs will be the ones executing trades, it’s important to talk with them to know what in the research they find most helpful when creating their investment theses. In case you are both the analyst and trader, don’t skip this step — talk to other traders your research may apply to and get their feedback.

Analyst-trader collaboration can help boost both the quality of research and trades.

Other resources: What Analysts Do at a Hedge fund in Invstopedia.