The World Is Changing … Hedge Fund Due Diligence and Risk Management Need to Change Too
By David X Martin and Enrico Dallavecchia
Management guru W. Edwards Deming famously said: “It is not necessary to change. Survival is not mandatory.” We all know what he meant. Given the ever-increasing velocity and intensity of change in the past few decades, it’s even truer now than in Deming’s day. Adapt or die.
The Past Versus The Present
Today’s environment of global tariff wars, nearshoring, technological decoupling, and the growing complexity of U.S. geopolitical priorities require a profound reassessment of how hedge fund investors conduct due diligence and how fund managers practice risk management. Investors and managers alike are operating in a regime defined by faster news cycles, greater tail risks, and a collapse of the assumptions that have governed global markets for decades. In short, the frameworks we have traditionally used to monitor and mitigate risk must now be reinvented for today’s more fragmented, volatile, and dangerous world.
Traditional hedge fund due diligence frameworks were designed to test governance, consistency, operational stability, and alignment. They worked well in a world where volatility was episodic, institutions were predictable, and market regimes were long-lasting. But that world is gone.
But today’s world is totally different: The pace at which narratives shift, capital moves, and confidence erodes has accelerated. Evaluating a fund manager’s strategy, pedigree, and service providers is still important, but it is no longer enough. Investors now need to assess adaptability — that is, how well a manager navigates an environment where macro and geopolitical shocks are not outliers, but structural features of the market.
Behavioral Interviewing
Historical track records during more stable times matter less than the ability to respond well to curve balls that come out of the blue. Investors should ask managers specific questions about past dislocations: “What did you do during the COVID shock? How did you respond to the inflationary regime shift? Tell me about how you managed through geopolitical disruptions, like Brexit or Russia’s invasion of Ukraine. Did you maintain discipline or shift risk aggressively – and why? How did you communicate with investors during these situations – and did investors respond well to your communication? What has been your biggest mistake as a fund manager … and how did you rebound from that mistake?” The best predictor of future behavior is past behavior, so you want to use behavioral interviewing – asking specific, behavioral questions about their ability to think on their feet, prevent blind spots, and respond in a crisis. Examples of past behavior are far more revealing than a Sharpe ratio or volatility statistic.
Beyond individual manager assessments, investors should also reconsider how they evaluate a fund’s contribution to the overall portfolio. It’s time to replace the traditional question, “Does this fund fit into our asset allocation framework,” with a more dynamic inquiry: “Will this fund continue to be additive under correlation breakdowns and volatility spikes?” It may seem counterintuitive, but a fund that complements the portfolio in calm markets may turn out to exacerbate losses in stressed conditions if it is exposed to hidden betas or crowded trades. Evaluating resilience across regimes is therefore essential – and more relevant than evaluating fit within a static allocation model.
Strategy Shift, Fund Resilience, and Managerial Alignment
Another critical dimension is the detection and response to strategy drift. In calm markets, investment theses remain intact and risk frameworks evolve gradually. In today’s volatile markets, even well-defined strategies may drift — either due to market pressure, investor demands, or subconscious behavioral bias. Therefore, continuous monitoring is just as important as the initial investment decision. Investors need to establish feedback mechanisms to track whether managers are adhering to their mandate, changing their exposure profile, or deviating from their stated risk appetite. Timely detection of such changes can prevent significant losses.
Service providers – often an afterthought — take on greater importance as the velocity of change increases. Prime brokers, fund administrators, legal advisors, and custodians must be resilient in their own right. Weaknesses in these relationships may not be visible in bull markets but they are vulnerable fault lines when stressed. Investors should evaluate whether these providers are robust, responsive, and appropriately scaled to the fund’s strategy and assets under management.
Equally vital is the evaluation of the fund’s operational and financial resilience. In a period where funding conditions tighten rapidly, and redemption cycles accelerate, managers with limited operational runway or excessive reliance on “hot money” are particularly vulnerable. A strong fund must not only perform but survive. This includes having lock-up provisions that are appropriate for the liquidity of the strategy, a diversified investor base, and a funding structure that does not rely on leverage to meet redemptions or cover margin calls.
In addition, let’s not overlook the importance of managerial alignment. Investors have always asked whether fund managers have “skin in the game.” But in today’s climate, the quality of that alignment matters more than its mere presence. Investors want to know: “Are key principals significantly invested? Are incentives designed for short-term performance fees or long-term capital preservation? Does the firm demonstrate a commitment to continuity and succession planning?” These factors become critical when markets turn and the path forward is unclear.
Fast Forward
Risk management, for both allocators and hedge fund managers, must now morph from a retrospective function to a forward-looking discipline that supports active decision-making. The speed at which information flows and markets reprice demands a new level of responsiveness. In past regimes, drawdowns unfolded over weeks or months. Today, they can materialize in hours. Such acceleration demands tighter trigger frameworks, revised stop-loss protocols, and scenario analyses that reflect not only market volatility, but political instability, policy shifts, and regional conflicts.
One of the major weaknesses in today’s investment ecosystem is the underuse of scenario planning. Many investors and managers continue to build stress tests around historical market events – while tail risks today are less about the recurrence of past shocks and more about the emergence of entirely new disruptions. The task is no longer to predict specific events but to understand how a strategy or portfolio behaves when fundamental assumptions break. This includes scenarios like the failure of a major global counterparty, the fragmentation of capital markets, the imposition of capital controls, or systemic technology failures.
The one thing we know for sure is: The future looks nothing like the past. We must ask ourselves: “What is unthinkable today, that if it happened, would completely transform our business?” Futurist Joel Barker, author of The Business of Paradigms, says that “when a paradigm shift occurs, everyone goes back to zero. Your past success counts for nothing.” Overnight, your highly successful firm can find itself back at Square One, along with everyone else, scrambling to operate within a new, unfamiliar paradigm. In other words, we all need to get proficient at thinking about the unthinkable.
Planning for the unthinkable means going beyond the numbers. It involves tabletop exercises, discussions around investment governance, and coordination across functions. The goal is not to eliminate uncertainty – an impossible task – but to build a decision-making framework that performs under pressure. The best institutions create a pre-defined set of responses that can be executed quickly during a crisis. This includes capital reallocation plans, hedging overlays, and communication protocols. In a crisis, there is rarely time to design new solutions. The ability to act must be embedded in advance. In other words, you need a Plan A, Plan B, Plan C, Plan D, and perhaps a few additional contingency plans.
Reporting frameworks must also evolve. Too many investors rely on risk reports that are backward-looking, overly quantitative, and disconnected from decision-making. These reports often emphasize variance and benchmark-relative returns rather than actual investment insight. What we need is a more holistic view of risk — one that incorporates liquidity, behavioral exposure, operational fragility, and geopolitical sensitivity. Reports should highlight not just what happened, but what is likely to happen and where the vulnerabilities lie.
Learning From Others
Lessons from other domains – particularly enterprise and cyber risk management – are instructive. In cybersecurity, the focus has shifted from how an attack happens to the consequences of the disruption. Similarly, investors should focus on the impact of market shocks, not just their causes. Whether the disruption stems from inflation, geopolitics, or regulation, the key question is: “How does it affect capital flows, portfolio construction, and operational continuity?”
Cyber risk management provides a valuable model for navigating today’s investment landscape. Because cyber threats can emerge and escalate in real time, the field has developed a culture of rapid response, constant monitoring, and contingency planning. This mindset — shaped by the need to act at “warp speed” — offers a useful analogy for investment professionals that are now facing, more than ever, a fast-moving geopolitical and macroeconomic environment.
One lesson we can learn from cyber risk professionals is the focus on identifying the “crown jewels” — assets or functions whose failure would be catastrophic. In hedge funds, this might include proprietary research models, key staff, execution infrastructure, or critical service provider relationships. These elements must not only be identified, monitored, and stress-tested regularly but also explicitly incorporated into the design and execution of stress testing exercises and crisis simulations. Too often, tabletop exercises are conducted without the direct participation of the individuals or teams responsible for these vital functions — which limits their realism and effectiveness. Ensuring that these stakeholders are actively engaged in scenario planning, decision-tree analysis, and post-mortem reviews helps uncover operational dependencies and coordination failures before a real crisis hits. Their participation strengthens institutional memory, improves cross-functional communication, and ensures that contingency plans are not just theoretical documents but practical tools ready to be deployed under pressure.
Today’s leading funds are already adapting. They are embedding risk teams within the investment process – not as gatekeepers, but as partners. They are using open-source data to detect behavioral changes in markets, applying machine learning to flag anomalies in trading patterns, and building institutional memory around past crises to shorten reaction time. These managers understand that risk is not a static concept but a behavioral process that evolves – often very quickly – along with the market.
Investor Relations
Communication with investors has also changed. Top-performing funds are increasing the frequency of updates, not only to report performance but to contextualize it. During volatile periods, weekly or even daily insights can preserve investor confidence and avoid redemption spirals. More transparency around positioning, risk exposures, and scenario thinking reassures sophisticated clients that the fund is in control, even if the market is not.
Smart allocators, too, are revisiting their approach. Family offices and endowments are re-evaluating how they define risk appetite. Rather than applying a uniform framework across asset classes, they are tailoring their approach to reflect the unique risk-return dynamics of alternatives. This includes defining not just how much volatility they can tolerate, but what kinds of losses are unacceptable and what types of risks are dealbreakers – risks they’re unwilling to assume under any conditions.
Conclusion
Decision-making in uncertainty remains one of the most difficult challenges in investing. But with the right structure it can become more manageable. Investors who define their values, constraints, and priorities ahead of time can move more decisively when the facts change. Those who wait until uncertainty resolves will likely find that the best opportunities have already passed them by.
This is not a time to retreat into safe havens or to freeze decision-making – nor is it a time to chase alpha blindly. It is a time to elevate process over prediction. Building a resilient investment process means developing the tools, people, and culture to respond effectively to rapid – sometimes unimaginable – change. It means that due diligence is not a checklist, it’s an ongoing conversation. And it means that risk management is not a shield, it’s a steering wheel.
50+ years ago, futurist Alvin Toffler wrote that both the rate of change and intensity of change were accelerating exponentially over time. Toffler predicted that we’ll ultimately arrive at the point where the speed and intensity of change become overwhelming, even paralyzing, and we will find ourselves living in a state of shock – Future Shock. That day is fast approaching. What can we do to prepare and/or prevent it?
These are parlous times, in which capital preservation and opportunity capture depend on institutional agility. Success will go to those who can identify real-time threats, adapt to new realities, and act swiftly without compromising discipline. That is not just good risk management – it’s survival.
David X Martin
CEO and CIO
Arctium Capital Management
Enrico Dallavecchia
President and CCO
Arctium Capital Management
Arctium Capital Management is an Outsourced CIO service provider specializing in hedge funds and alternative investments, with a core focus on uncorrelated alpha—a strategy designed to deliver returns independent of market swings. Our flagship Arctium Uncorrelated Alpha Fund seeks capital appreciation, particularly during market downturns, by generating returns with minimal correlation to equity and fixed income markets. Led by two former Chief Risk Officers of major financial institutions, our team brings deep expertise in markets and risk management. Arctium partners with endowments, family offices, pension funds, and insurance companies, offering customized OCIO solutions, hedge fund due diligence, and institutional-grade risk management.
