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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:

  1. (Optional) Alignment with Vocational Self-Awareness
  2. Alignment with Portfolio/Fund Construction;
  3. Alignment with Portfolio/Fund Expectations and Requirements;
  4. Alignment with Risk Management & Compliance;
  5. Going Deep;
  6. Unique Angles;
  7. Research Model/Process Consistency;

(Optional) Alignment with Vocational Self-Awareness

Before even beginning, it’s important to know what kind of analyst you are. This not only dictates the type of work you will like to do, but also how you will communicate with others, what you can expect from yourself and what will resonate most with you.

This is covered in further detail in the Vocational Coaching in Asset Management article, but using a quick assessment like the RIASEC one can yield quick conclusions: high Conventional means you will be a fan of structured, systematic work while high Artistic means you will be be strong in innovative, new ideas. High Enterprising will mean you will tend to want to persuade others with your ideas while high Social means you will want to help others with their issues.

Self-awareness is not just for people who are doing vocational self-assessment, but also for analysts/PMs that do goal setting or just explore how to improve their skills and education.

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.

Traders and PMs who do goal-setting are usually very adept at this. They know exactly what they must make in a year, how to split that monthly, weekly and in some cases even daily, how many ideas they must generate and the P&L they have to achieve with each idea.

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.

Going Deep

An analyst that just touches on the superficial aspects of a company is very different from an analyst that takes a deep dive and fully knows everything about the company ranging from possible things like cashflows, entry and exit of key people, quantity and types of debt, comparison with the industry, functioning of similar companies, interviewing and sourcing previous employees or other related people that can substantiate (public) information, and/or others.

Say that research should be “deep” sounds so simple, yet it’s taking it a completely different level. You can just see when a piece of analysis just takes care of the obvious/simple metrics of a company, or whether this person did really work into really digging into every possible aspect that is relevant to execution.

Just two of the “famous” hedge fund partners known for their analytical prowess are Bill Ackman from Pershing Square (his analysis for the MBIA short documented in the book Confidence Game by Christine Richard, who later joined him in research for future possible shorts like the Herbalife one) and David Einhorn (whose short against Allied Capital was documented in the book Fooling Some of the People All of the Time – no affiliate link for any of the two books). Reading any of these two books or knowing more about Ackman or Einhorn’s processes will illustrate how properly diving deep in an analysis should be, and how many additional layers it requires from the initial superficial analysis.

Unique Angles

Related to the previous post, developing unique angles of research can help you develop unique research. At any one point, there is an infinity of information you can obtain to corroborate a play. For example, just for a stock, you can investigate:

  • Credit volume and type;
  • Accounting practices;
  • Entries and exits of key talent;
  • Sophistication and level of knowledge of investors with the opposite view (short/long);

Developing your unique method of research comes down to researching the specific dimensions that corroborate your thesis and giving more priority to those. Of course, this is impossible to do a priori, but as you create subsequent research pieces, you will realize which information is usually useful, useless, overrated or usually forgotten.

If you want to take it a step further, you can go with unique methods of research that either leverage unique points of view you have, your experience, or just things other people don’t look for:

  • In one case, a PM client of mine developed a research method based on CEO charisma. He defended companies whose CEOs had great charisma were an issue, as they would have the tendency to hide bad results or to make investors ignore them based on the pure magnetism of personality. Apple and Tesla were examples;
  • In one case, a PM from the team of a CIO client was fascinated with social patterns (as those you see on Alex Pentland’s Social Physics). He examined the social patterns of product adoption for certain companies, for infectious diseases and other purposes;

Regardless of your background, you will have unique skills you can leverage as a unique analysis angle. For example, being a coach, I’ve never done investment analysis, but I always think that if I did, I would do involving analysis the personalities of different leaders and analyzing the corporate impact of it.

The goal is make these angles replicable so they can be instituted as research criteria for portfolio/fund-level, which will be important for the fund manager to raise capital.

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 the 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.

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