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Because hedge funds are typically unregulated by any independent authority, the risk of manager fraud is higher with hedge funds than with regulated investment entities. Many investors fail to sufficiently investigate funds in which they are considering an investment. The manager’s background, experience and track record are key factors that need to be verified. If possible, one also should speak to current investors about their experience with the fund, verify educational and employment history of the key managers and thoroughly review all fund documents. Most managers are willing to speak with investors about the investment strategy and fund operations. One also should visit the fund’s headquarters and meet the manager before allocating substantial capital.
Extensive due diligence prior to investing is only the first step. Once an investment has been made, it is very important that the investor continuously monitor the hedge fund so that he can react to changing market conditions or changes at the individual fund level. “Style drift,” whereby the manager does not adhere to his mandate, usually is an important danger signal; e.g., a “market-neutral” manager with equal dollars in long and short positions decides to take a chance that the market will rise and becomes 75% net long. Caution! The majority of hedge fund legal documents allow the manager far greater latitude than his marketing materials may suggest. Therefore, the investor should consistently review the fund’s performance and strategy to ensure that there is little or no style drift. If a manager does stray from his stated strategy, the investor must determine how that could affect his overall portfolio and whether the fund still meets the investor’s needs.
While the quantitative aspects of a fund are very important, a prudent investor should also carefully examine the qualitative aspects of potential funds; i.e., analyze the strategy for different market conditions. Also, there are many key factors that will determine whether a fund is a suitable investment for an individual investor: the investment strategy, the fund’s liquidity and its use of leverage. Many funds may have a phenomenal track record but may have assumed greater levels of risk than a particular investor desires. The returns of two funds following the same strategy should also be examined and compared to one another. While one fund may have outperformed the other by 25%, it may have achieved this record using twice the leverage. This would tend to indicate that the skill of the lower-returning manager actually is superior to that of the one using twice the leverage and may be a better indicator of which fund will provide positive returns in the future with less risk.
A mistake investors often make is constantly reallocating to the “latest and greatest” manager. Too often, yesterday’s upside outlier is tomorrow’s downside outlier. A more prudent course of action is to look for funds with consistent acceptable performance relative to their stated strategy. Look for managers with concentration limits and risk controls in place that will improve their likelihood for absolute returns with low volatility in future market environments.
Just as with traditional investing, it is very important to construct a well-diversified hedge fund portfolio. Due to high investment minimums, many investors cannot afford to allocate capital to more than one hedge fund manager or may choose to make just one investment to “test the waters.” With a single hedge fund investment, one is subject to the risk that the individual manager will run into difficulty as well as the risk that the chosen fund’s strategy will not perform well. If an investor is planning only one hedge fund investment, it is much safer to invest in a broad investable hedge fund index that will provide diversification across all strategies.
Understanding the manager’s strategy, before investing in a hedge fund, is important on two levels. First, if a manager cannot adequately convey his investment strategy to investors, it may signal that he either is not capable of successfully implementing the proposed strategy or, in extreme cases, that he is trying to hide aspects of his strategy. Secondly, if the investor does not understand the fund’s strategy, he will be unable to conceptualize its expected return and its risks in varying market conditions. As a result, he will be unable to diversify with investments that will have offsetting returns in a particular market environment.
The statistics that Greenwich Alterative Investments reports monthly are based on the average hedge fund performance reported for the month. There is a wide range of performance around this mean and to find the better-performing hedge funds, it is very important to have a large selection of hedge fund from which to choose. It is highly useful to compare characteristics of an individual hedge fund to other hedge funds using the same strategy. This is impossible to do without having a large sample from which to select and compare managers.
Many investors attempt to diversify by using numerous managers but do not incorporate enough hedge fund strategies. Managers with the same strategy will be affected similarly by market conditions. It is highly useful for an investor to construct a portfolio of hedge funds that can provide returns in all market conditions and that is adequately insulated from market shocks. Most investors do not have the expertise to accurately predict the performance of each strategy under varying market conditions and therefore to properly construct a diversified portfolio.
One of the biggest mistakes investors make is not including enough hedge funds in their portfolios. Many investors who can afford only one or two hedge fund investments are attracted by the stellar track record of an individual hedge fund when the most prudent investment would be a fund of funds. Due to the lack of regulation and use of leverage, short selling and derivatives, many individual hedge funds have an inherent level of risk that mutual funds do not. Unless an investor has enough available capital to construct a properly diversified hedge fund portfolio, we strongly recommend funds of funds.
When analyzing a potential hedge fund investment, an investor should consider many factors in addition to the performance history and background of the managers. One important aspect that many investors overlook is the fund’s risk controls including concentration limits, operational controls, leverage limitations, liquidity of investments and extent of hedging. These risk controls are usually tested only in market crises and many less experienced managers have not been through enough market cycles to fully appreciate their necessity.
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