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HEDGE FUND DUE DILIGENCE: A SOURCE OF ALPHA IN A HEDGE FUND PORTFOLIO STRATEGY Stephen J. Brown, Thomas L. Fraser, Bing Liang1 First Draft: July 18, 2007 Current draft January 21, 2008 Abstract Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly – or fail – due to operational risk concerns. However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that we document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment. JEL Classification: G1, G2 Keywords: Hedge funds, operational risk, due diligence, alpha Contact author Stephen J. Brown David S. Loeb Professor of Finance NYU Stern School of Business 44 West 4th Street, Suite 9-190 New York, NY 10310 Telephone: 212 998 0306 FAX: 718 981 7239 e-mail: sbrown@ 1 Stephen J. Brown is the David S. Loeb Professor of Finance at New York University Stern School of Business, Thomas L. Fraser is an attorney in New York City and Bing Liang is Associate Professor of Finance at the University of Massachusetts at Amherst - Department of Finance Operations Management. Please direct email correspondence to sbrown@ and tom@. Electronic copy available at: /abstract=1016904 I. Introduction Fun