Unlike traditional investments, hedge funds require a distinct due dili- gence process that is usually best undertaken by professionals with spe- cific expertise in alternative investments. Because of the complexity involved, investors are increasingly availing themselves of the opportu- nity to make alternative investment allocations through a pooled vehicle managed by a hedge fund expert, namely a fund of hedge funds (FOHF).
These portfolios of hedge funds can offer the most attractive risk- adjusted rates of return with low to zero correlation to most traditional portfolios and far less volatility. (See Figure 1.2.)
For those who do not meet the definition of an accredited investor, investing in a fund of hedge funds is currently the only way to gain access to absolute return strategies in any form. Thanks to an increas-
The Hedge Fund Alternative 19
Single Hedge Fund Fund of Hedge Funds
•
•
Minimum investment $1 million per hedge funda
•
1-year lock-up
•
1% management fee + 20% performance fee
• Minimum investment $1 million
• 1-year lock-up
• 1% + 10%*
Fund Mgr 1
Fund Mgr 2
Fund Mgr 3
Fund Mgrx Fund
Mgr
1% Management Fee + 20%*
Performance Fee
FIGURE 1.2 Two Primary Approaches to Investing in Hedge Funds.
aTo achieve the diversification for managing risk, a substantial investor would invest in multiple hedge funds (e.g., 10, with a total investment of a minimum of $10 million in this asset class). Assuming absolute-return strategy investments comprise 10 to 30 percent of the investor’s total portfolio, this approach involves investors having $35 million to $100 million in total investment assets, thereby significantly limiting the number of qualified investors having access to this investment solution.
*Typical performance fees range from 10%–20%.
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ing number of registered FOHF, those with as little as $25,000 to invest will have more opportunities to access and benefit from absolute return investment strategies. Even individuals and institutions with substantial financial resources and significant investment experience are taking advan- tage of the benefits of investing completely or partially through a FOHF.
There are three main advantages of FOHF investing:
1. Professional management in the identification, evaluation, selection and monitoring process, as just outlined
2. Access to funds
3. Diversification among selected strategies and managers
In terms of access, while not true of all funds of funds, certain high- quality funds offer long-standing relationships with many of the most prominent funds in the world as well as a network of niche strategy managers. Commingled multimanager partnerships can provide access to these funds and strategies that are otherwise inaccessible. In the alter- native investment field, adequate diversification is essential. Due to the volatile nature of many individual funds, investors need diversification among strategies as well as among managers within each strategy. The issue of diversification is a natural adjunct to that of access.
With account minimums at top-tier funds averaging over $1 mil- lion, an individual investor would need to make a commitment of at least $10 million to hedge funds to achieve the minimum level of diver- sification required. Once again, funds of funds provide the required broad diversification among strategies and managers for a significantly smaller capital commitment.
20 HEDGES ON HEDGE FUNDS
TIPS
Wealthy individuals have been investing in hedge funds since A.W.
Jones & Company started the first fund in 1949. Today, thanks to the pedestrianization of hedge funds, this investment strategy is increasingly relied on by “mass affluent” investors to enhance their portfolios. How to begin, however, is often a challenge.
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The Hedge Fund Alternative 21
■ Evaluate your status as an accredited investor and work with your advisor to determine the appropriate portfolio allocation to hedge funds.
■ Before jumping into the asset class, learn everything you can.
There is a myriad of styles and strategies, and one size does not fit all.
■ Investigate the various hedge fund strategies and talk to your advisor before making a decision how to invest in hedge funds.
■ Acknowledge that the concept of hedging implies a reduction of risk. If your financial advisor or others tell you hedge funds are risky, realize that this is an all-too-common assumption.
■ Decide if you would be better off with a tailored hedge fund portfolio or an initial investment in a fund of hedge funds.
■ Pay close attention to the fees and other investment terms of the hedge fund manager(s).
■ Inquire whether managers have their own capital invested in the fund, which shows commitment and aligned interests.
■ Realize that hedge fund managers seek absolute returns, not returns that are relative to the broad market. Most of the returns from hedge funds result from the managers’ skills rather than the returns of an asset class. Stop thinking just of the Dow or S&P 500.
■ Ask about the level of transparency and disclosure that will be provided by hedge fund managers—that is, how much infor- mation will be provided about fund activities.
■ Insist on thorough, expert due diligence on hedge fund man- agers before entrusting them with your money.
■ Remember, hedge fund investments have different tax report- ing and implications from other investments. Check with your accountant before making an investment.
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