Ultimately a fund investment is a matter of trust — do you trust that a fund’s management will do what they say they are going to do with your capital? The institutional investor approach to the trust issue is to conduct an extensive due-diligence (DD) of any new, emerging manager, they consider for an allocation. Quite often the manager is asked to complete DD-forms comprising 100’s of items covering all aspects of the business, many of which require supporting documentation in response. Add to that a string of interviews with the fund’s management. Understandably, individual investors usually don’t have the resources, the knowledge and even the time for such a rigorous DD-process. There is however a relatively short checklist of questions that an individual investor can quickly cover, which will identify funds that do not live up to the minimal standards one should require from businesses that manages other people’s money.
Roughly, one can divide the DD-questions into two categories:
- Questions around the historical performance of the fund and its ability to generate good returns in the future.
- Questions around the overall setup of the fund, the people, the legal structure, the key service providers etc.
In this piece, we are going to focus on the second category of questions — the ones around the setup of the fund/investment manager. Usually the performance get most of the attention, and we will adress what questions to ask around that in part II of this article — but in our opinion, scrutinizing the setup is equally important, and in some cases, more important than the performance. The key concept here is transparency — if a fund does not promote transparency in the way it is set up — can one really trust that the stated performance is what they say it is and/or that it was generated in the manner they say it was? Furthermore, by not having a solid setup the exposure to other risks, besides market risk, will be unnecessarily high . Some of these other risks may be devastating to your investment — if they materialize. According to a study by Capco:
50% of hedge funds shut down because of operational failures, followed by investment issues at 38%.
The questions below are high level questions that naturally prompt follow up questions if the answers are not satisfactory. Several of the questions are not specific to digital asset funds but in the traditional asset world the setup is likely more solid/mature by default. An unsatisfactory answer to the questions below does not disqualify an investment as long as there is a good explanation for it — but if you are getting vague answers on any of the questions and/or there is little they can provide in terms of supporting documentation then that is a big red-flag. Going through the checklist does not guarantee that you are not investing with dishonest managers or that their setup will not run into trouble — but it is likely that it will reduce that risk and you will feel more comfortable about your investment.
CHECKLIST OF QUESTIONS:
- Who are running the fund and do they have suitable/credible backgrounds to run money? It is more comforting if the key people have an established online footprint vs. nothing at all or a very small one — some sort of career usually produces a digital trail nowadays. It is somewhat likely that you at least know someone who knows someone who used to work with some of the people in the fund and who can give you some feedback (check the connections on LinkedIn).
- Does the fund have a fund administrator and who is regulating it? If the fund does not have a fund administrator that is a big red-flag — as there is no independent verification of the value of your holdings in the fund. Every serious investor in a fund would require a fund administrator and every serious fund manager would employ one. Ideally you want the administrator to be located in, and regulated by, the authorities in countries that has a strong/sophisticated financial sector — typically countries ranking high on this list, say top 20ish, with some exceptions.
- With which bank does the fund account reside and in what authority regulates it? Again, ideally you would want the bank to be located in and regulated by the authorities in countries ranking high on this list.
- Is the fund audited? Is the auditor a well-known reputable international firm or some obscure firm that most people have never heard of? An audited track record enhances trust and makes it more likely that the business is run in a prudent fashion.
- Ask for the fund prospectus. Once you get it — read it. A big chunk of every prospectus consists of template language which you can skip but the parts you may want to pay attention to are where they describe the investment strategy, the risk management, the conditions around redemptions/investor liquidity and whether the fund has the right to gate your investment.
- Is the fund regulated and by which authority? A regulated fund have a higher degree of oversight and is obliged to provide regulatory reporting to the regulating authorities. However, not all regulations are created equal and most digital asset funds are not subject to the level of regulation that AIFM, UCITS, 40-ACT and similar frameworks dictate. It is in general significantly more expensive to run a heavily regulated fund and this will likely affect investor returns (especially for smaller funds). Many funds are located off-shore with weaker regulation than on-shore. For example, more than 75% of the world’s hedge funds are incorporated in Cayman Islands — and most well known asset managers have entities registered there. In the off-shore case it gives more investor comfort if the fund has some kind of on-shore presence and the key service providers are on-shore and regulated etc.
- Does the fund have an advisory board and who are on it? Is the advisory board active and not just for show? Ideally you want knowledgeable established people on the advisory board and you would like the advisory board to be involved in the discussions around the best strategy for the business.
- Does the fund have any external directors? Allowing an independent third party to scrutinize the business adds to the trust.
- How long has the fund been in operation? The longer, the better as it signals stability/continuity of management. Digital assets are a young asset class but everything is relative and all things being equal, a 3 year track record is better than a 1 year one and so on. We are believers in the Lindy effect.
- How does the fund store its digital assets ? Does it use any 3rd party custodian? What measures are in place to reduce the exposure to cyber crime? Digital assets are essentially bearer assets — so very little prospect of recourse if they get stolen.
- Does the fund utilize side-pockets and how much of total AUM reside in those? Side-pockets signals illiquid- and hence hard to value assets which in turn implies a high uncertainty around the value of those holdings – it can only be properly determined once your are trying to sell the assets. This uncertainty gives the manager more leeway to intentionally mismark their value. Side-pockets reduces transparency. Be aware of the implications and risks of a fund having a big chunk of their assets in side-pockets.
Lastly, ask yourself if you get a good feeling when talking to the representatives of the fund? If not, it is probably wise to refrain from investing and move on to another fund. Set yourself up for a pleasant “investor journey”.