Author: FundFront– FundFront.com

Including hedge funds in an investment portfolio can add significant value by providing better risk-adjusted returns with low correlations to traditional investments. If you’re looking to invest in hedge funds, knowing how to select each opportunity is essential.

But how do you search for hedge funds? How do you choose the right one? And what about the risks involved? Luckily, we have answers.

There are specific guidelines for selecting hedge funds-covering everything from research angles to investment strategies. In this guide, we’ll provide an overview along with examples to help you in your hedge fund selection journey.

To summarise the process:

• Research funds, also called sourcing
• Perform initial screening on a larger number of funds
• Create a short list and perform detailed due diligence on these
• Select the fund(s) to be invested in and continue to monitor performance of the selected funds and those on the short list

There is a bewildering array of funds out there, from very large asset management firms to much smaller boutiques, all vying for investors’ attention. Each fund management firm has its own approach, biases, markets they operate in, mix of products, and other characteristics.

In terms of hedge funds and their differences, it’s necessary to consider: what are their characteristics, their behaviours, what markets do they invest in, are investment decisions technology driven or human driven (or some mixture of these), how fast do they make those decisions, how long have they been operating, and so on. This is a complex list of characteristics, and it can be hard to quantify or find the data on all of them. There are broad based categories of funds, like the taxonomy shown in the figure below. This is not meant to be an exhaustive list, just an illustration of some common fund types and how they typically differ. The data is from the Credit Suisse hedge fund indices, found here.

Figure 1: Taxonomy of broad hedge fund types

All of the fund types given in Figure 1 are quite different to each other, and all require different sets of expertise to analyse. It’s this complexity which makes the fund sourcing and selection process challenging.

One of the main reasons we need to go through this process in the first place, is the dispersion in hedge fund returns. In other words, there are large differences between the worst and the best performers, over various periods of time. Simply selecting some random set of funds for a portfolio will likely produce mediocre returns. Dispersion of fund returns is shown in the chart below.

Figure 2: Dispersion of hedge fund returns by strategy, from Aurum.

Sourcing suitable funds is the first step in the overall process. It requires going through all applicable fund managers (where applicable might mean that there is some initial filtering at this stage based on things like fund manager location, assets under management, time period in business, or other factors). The output of this stage is a filtered list – a long list – of fund managers that might make good investments, but require some more detailed analysis.

There are multiple avenues of information where you might find fund managers and appropriate information on them, including:

• Databases
• Industry awards and recognition
• Word of mouth
• Events
• Online search
• Social networks

Certainly, these sources, together with contacting funds directly for marketing materials, provide a set of information that can help start the analysis. But in reality, a much more detailed process is required – that of ‘due diligence’, discussed in the next two sections.

From the long list of the previous section, we need to start filtering to narrow this down to a number of potential funds that is more manageable, especially if we will look at them as part of a time-consuming detailed diligence process.

The initial screening needs to answer some key questions which come from the target investor characteristics, the desired performance, and other requirements. Answers to these questions can come from a standard questionnaire template as well as available marketing material such as strategy presentations and factsheets.

This is a key part of the process, and one which potentially takes the most time. It’s also a process that individual investors do not typically follow – it applies more to larger, institutional investors or family offices. It’s still worth going through it as it highlights some of the considerations in choosing fund managers. There are multiple stages or parts here, covering the investment process, approach, team, track record, and operational aspects also. What helps here is having a well thought out, consistent, framework to follow. Our own internal framework is structured around these key points:

1. Profitability – the manager’s ability to generate returns
2. Stability – the potential for those returns to fluctuate over time
3. Consistency – how consistently does the strategy delivers positive returns, and how likely is it to continue doing so in the future
4. Control – control over the strategy in terms of operations as well as its risk of creating drawdowns
5. Liquidity – the ability to rebalance the portfolio effectively around different events, for example redemptions, losses, and so on

Going into some more detail as to the typical points that need to be covered, and the specific questions that need to be answered:

• Investment results – Performance, stability, length of track record, and measured using how much assets under management. Hedge fund performance or alpha, is covered in the next section.
• Investment philosophy and approach – How are investment decisions made? Who makes the decisions? Which markets, assets, techniques are used as part of this process?
• Team – How long has the team been managing money? Is there key man risk?
• Risk management – A key issue in fund management, monitoring and controlling risk of trading positions as well as portfolio leverage allows for more control over potential drawdown events.
• Operations – A sign of a more mature and investible firm is a robust operational infrastructure.
• Fees – What fees does the fund manager charge and is it appropriate for the type of fund / type of investor / performance characteristics.

Obtaining a completed due diligence questionnaire from the fund manager should cover some of the points above, although a series of meetings is also required to get the information needed.

Two of the key questions that many investors eventually grapple with is how to measure the performance of a single hedge fund, and how to compare the performance of different hedge funds. Perhaps the most well-known method of comparing fund performance is using a measure called alpha which is illustrated in the chart below. By plotting the returns of hedge funds against the corresponding returns of the market, and draw a straight line through these points, the intercept point in terms of fund return is the alpha.

Figure 3: How alpha is calculated

Alpha measures the outperformance of a given hedge fund against a selected benchmark. The obvious question that arises next is what benchmark should be used? The benchmark in the chart above is simply the market returns, so in the US market this is the S&P 500. The problem with comparing against an equity index is that hedge funds do not typically allocate all of their capital to equities. They invest in a variety of instruments, including complex instruments like derivatives.

The most realistic benchmark may be a correspondingly complex mixture of assets and investable instruments, but a more easily calculated proxy is a mixture of stocks and bonds. Bonds generally have less risk than stocks so the overall benchmark is typically less risky than one made up purely of stocks. The relative amount of stock or equity exposure in this proxy is related to how much the fund in question invests in equities, over a long time period. For many funds, that relative amount of stocks exposure might be 50% or even less. What that also means is they don’t have the same amount of risk as investing purely in the stock market.

For some funds, there is no easily producible and representative benchmark, particularly in the case of funds that often go short, use derivatives, and other complex products. Therefore, another way of measuring fund performance is by using the absolute return. In this case it’s not just the actual return of the fund that matters, but also the return in context of the full spectrum of risks that are associated with generating those returns. Perhaps the most important of the risk considerations is the expected maximum drawdown.

Fund returns ideally go up, so invested capital increases. But unfortunately, there are sometimes episodes where an investment’s returns go down. As long as performance recovers in a reasonable time span, this is generally acceptable. The period when the fund value goes down and then back up is called a drawdown. Having an idea of what the maximum expected drawdown might be, and how often drawdowns occur, is a key performance measure for a fund.

An illustration of a drawdown is shown below. Here, the investment returns gradually increase up to a peak value. After this, there is a reduction down to a valley – a local minimum. It’s the difference between peak and valley that gives the drawdown amount, expressed as a percentage.

Figure 4: Illustration of drawdown

Of course, it can be hard to estimate. For example, funds that are based more on human decisions will rely on live trading data to estimate drawdowns. Whereas computer driven funds can use a simulation to estimate what the expected drawdowns might be. That said, both of these cases are estimations – markets are dynamic and somewhat unpredictable environments and so all investments can behave in ways that are unexpected.

The final stage of the process is fund selection and monitoring. Selecting the correct set of funds and having the right mix depends somewhat on the eventual portfolio that is to be constructed. The funds that are selected should be uncorrelated with each other as well as with the overall market itself. Performance of the funds selected needs to be continually monitored, and there should also be regular meetings and updates with the fund manager(s). In addition, other funds on the short list should be monitored and considered for selection in the future – this is an on-going process.

As we have seen in this document, Hedge fund manager selection and due diligence is a time consuming and resource intensive undertaking, requiring significant expertise and experience. First, there are thousands of hedge funds available to investors with a wide dispersion of performance that creates both opportunities and risks. Second, few investors have the expertise necessary to properly evaluate funds due to the broad range of asset classes, geographies, and strategies.

Luckily, there are simpler ways. Multi-manager investment platforms offer access to a carefully selected menu of different fund types which investors can use to create a multi-strategy portfolio. They provide access to the data, analytics and insights you need for quick and informed decision-making, so you can manage your whole hedge fund portfolio in one place.

Components of a multi-strategy portfolio enable investors to combine individual fund types to create a custom portfolio of individual strategies. Combining these different fund types together can potentially give you an overall return profile with better risk-adjusted performance than each of them individually. This may mean returns that are more reliable and less prone to periods of market stress.

If you need guidance on how to select the right investment platform, here are more resources for you to get inspired.

Additional reading

1. Hedge Fund Due Diligence, read more
2. What is Alpha, read more
3. A Guide to Multi-Manager Investing, read more.