The fund of hedge funds that are the most consistent tend to be run by experienced portfolio managers with either an equity market neutral stance or a convertible arbitrage emphasis
Portfolio diversification has always been an important concept for institutional investors.
The problem has been how to find genuine diversification opportunities. One of the most interesting lessons to have emerged out of highly volatile markets is that hedge funds, used correctly, have provided genuinely non-correlated returns.
Building a portfolio of hedge funds is not easy, and requires considerable knowledge and skill. The most obvious way for institutions to enter the market is via a fund of hedge funds, which provides ready-made access, due diligence and diversity. Research shows that hedge fund of funds ' illustrated by the InvestHedge global multi-strategy index, which reflects the median performance of around 600 'multi-strategy' fund of funds vehicles ' show a distinct lack of correlation to equities, particularly in bear markets.
While the diversified hedge fund portfolio median underperforms equities in the bull market, as the latter began to fall off in 2000 hedge funds showed steady gains. But for institutions that have taken this on board, the way forward is far from easy. Once an investor has decided to go down the route of investing in fund of hedge funds they are faced with the problem of how to implement their strategy.
With well over 1,000 funds of hedge funds available there is still a bewildering degree of choice for the potential institutional investor. Any expression of interest is likely to lead to a glut of prospectuses and information. Despite sharing the same goals of diversity, non-correlation and preservation of capital, funds of hedge funds differ radically in their approach and investment style.
Many funds of funds were originally vehicles aimed at the high net worth individual market and are only now waking up to the potential of the institutional market and trying to raise business there. High net worth investors are more likely than institutions to be focused on strategies that have historically made strong returns for which they are willing to stomach higher levels of correlation and volatility.
One would naturally expect the risk/return profile of a macro-focused fund of funds to differ strongly from one focused on, say, arbitrage strategies. The problem is that, for the new investor looking for a broad-based introductory vehicle, there are nevertheless very wide divergences even within the global multi-strategy sector.
Many global multi-strategy vehicles, for example, have a high equity component in this sector. While equity long/short funds can be contributors to the performance track record of a fund of funds ' they made, on the whole, excellent returns in the bull market run-up of the 1990s and for the most part have held onto those gains in the bear market ' directional long/short equity strategies often tend to be long-biased and have not performed well in general over the bear market.
The strategies that have historically achieved the most consistent risk-adjusted returns have included an equity market neutral component.
It is no surprise that the institutions at the cutting edge of hedge fund investing, such as Netherlands-based ABP and MN Services, have chosen to focus on these strategies which, when combined properly can offer not only high risk adjusted returns but low correlation to traditional asset classes ' essential for effective diversification.
However it is not just at strategy level that funds of funds differ very widely. The barriers to entry to the fund of hedge funds market are relatively low and it is essential that the quality and experience of the portfolio managers and analysts is examined carefully.
The level of complexity within hedge fund strategies should not be underestimated and it is imperative that the fund of hedge fund manager has a deep understanding of the underlying trading strategies of all funds in his portfolio. Without this, proper risk management is impossible. Many industry observers now believe that it is crucial that those responsible for hedge fund evaluation and risk management should have had direct experience trading hedge fund strategies themselves.
Diversification within a portfolio is highly important as a risk-control measure. However some funds of funds appear to have a relatively unsophisticated process of achieving diversification, with between 35 and 50 managers who are more or less equally weighted.
Diversification between funds, strategies and sub strategies that exhibit low correlation to each other is a prerequisite to good risk management but requires a very detailed understanding of the strategies involved.
The nature of investing in hedge funds ' with the best performers having finite capacity and often filling up relatively quickly ' means funds of funds are constantly having to look for new ideas and potential holdings. Some funds of funds, as a result, can end up with a large number of holdings in their portfolio ' as they downgrade existing managers who are failing to live up to expectations and try to buy available capacity in newer holdings.
While this process is unavoidable to some extent as a transitional measure, in the hands of an indecisive manager it can lead to a long and persistent 'tail' on portfolios which can in effect diversify away some of the return.
Another potential drag on performance is the thorny issue of 'event risk'. Although this can also happen in the long-only world and to the most reputable of institutions ' as those who remember the Barings and Morgan Grenfell scandals of the early 1990s will testify ' the relatively unregulated and unconstrained investment parameters of the hedge fund world mean that such things can and do occur.
While some blow-ups are a case of outright fraud or falsification on the part of underlying managers and as such are hard to guard against, a record of investing in funds that blow up could be indicative of a lack of sufficient due diligence processes, skill or risk monitoring.
Managing a fund of hedge funds is neither science nor art, but a unique combination of the two. Historic performance numbers ' while very important ' do not tell the whole story and it is only by delving into the detail of the portfolio management process and those that implement it that investors can make an informed choice.
Stephen Attenborough, head of European sales, fund of hedge funds, Gartmore Investment Management
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