As a group, hedge funds are pools of investment capital that have the flexibility to employ a vast range of trading strategies in both traditional and non-traditional markets. Because of this versatility, hedge funds can bring diversification to a portfolio that is hard to find elsewhere. However, the flipside to having all of these options is that hedge funds rely more heavily on manager skill than market performance in order to generate returns. That’s why the difference between the best and worst performing hedge funds is much larger than with traditional investments, making choosing the right investment manager even more critical.
How Can Hedge Funds Enhance Diversification?
Creating a truly efficient portfolio relies on bringing together investments that respond to market events differently. Diversification potential offered by hedge funds comes from:
- A broad opportunity set and fewer restrictions on investments allow more opportunities to discover investments that are less correlated.
- Less dependence on market direction, which can help to minimize volatility.
- Trading strategies that seek out market inefficiencies, where highly skilled managers can add significant value over time.
Not All Hedge Funds Are Created Equal
Compared to more traditional stock and bond investments there has been a larger spread between the highest and lowest returning hedge funds. The chart below shows figures for the period from 2004 to 2013, where the spread was 44.2% for hedge funds, compared to 10.2% for large cap core funds and 4.2% for U.S. government bond funds. This large variation in hedge fund returns is what makes the careful selection of specific managers and funds critical.
What to Consider When Choosing
Choosing a manager based on their past track record is a given, but there are other factors to consider that are arguably just as important:
- Investment objective. What are you trying to achieve with this investment (i.e. lower volatility, enhanced return, less correlation to other investments)?
- Structure. Are you looking to select a single manager / strategy fund to build out your own allocation to hedge funds or are you looking to select a fund of funds to manage an allocation for you?
- Team. What is the makeup of the investment team in terms of diversity, experience and history, and the culture of the overall organization?
- Risk management. Is risk management an independent function that provides checks and balances to the investment process?
- Operations. Does the fund have a sound operational infrastructure backed by dedicated support groups (i.e. legal, technology, due diligence) to allow the investment team to focus solely on investing?
Hedge Fund Strategies: Defined by Area of Focus
In our view, hedge fund strategies can be categorized by area of focus and whether they seek to generate fairly stable returns regardless of the market environment or seek to capitalize on movements in underlying markets. Some of the most recognized hedge fund strategies are:
- Long/Short. Involves buying and/or selling equity or credit securities believed to be significantly under- or over-priced by the market.
- Managed futures. Invests in various global futures markets and takes both long and short positions in assets such as agricultural products or precious metals.
- Global macro. Takes views on the direction of markets and seeks to profit from changes to broad securities markets, interest rates, exchange rates and prices of commodities.
- Distressed. Purchases securities of companies that are going through restructuring and looks to profit from the securities once restructuring is complete.
- Multi-Strategy. Flexibility to invest in multiple hedge fund strategies at a given time.