Hit the Books

Hedge funds can produce very healthy returns for s

Hedge funds have experienced several spectacular blowups in the past few years. But they continue to offer one of the best opportunities for high-net-worth investors to leverage some of the brightest minds in the money management industry. Before you dive in, prudence dictates thorough due diligence: Investing in hedge funds requires extra homework.

To determine if hedge funds are right for you and your clients, every advisor should follow five steps that will arm you with a framework for understanding how hedge funds can be used in a portfolio, and help you create a unique process for selecting funds.

Step 1: Determine Your Investment Objectives and Constraints

You need to define the investment objectives and constraints that your clients are willing to accept, using a standard set of criteria based on risk tolerance, return requirements, and investment constraints.

When defining your client's risk tolerance ask these questions:

o How much volatility in the portfolio value is the client willing to accept?

o How much volatility is acceptable in the fund itself and in the context of the investor's total portfolio?

o Which asset classes are appropriate for the investor's total portfolio and the fund?

o What asset mix is the investor willing to allow, and how much discretion does the manager have in making these decisions?

Then determine the form of return and expected return that will match the amount of risk that the investor is willing to take. In some cases, the return objectives may not be to optimize investment returns within the established risk tolerance parameters, but to offset areas of exposure in the rest of the portfolio to limit the potential of overall loss during turbulent or falling markets.

Remember most funds are set up as "pass-through" entities. So rather than owning shares in a company that owns securities, the investor actually owns a slice of the underlying securities. Therefore, the investor's return objectives in terms of return form--ordinary income or capital gains--can have a significant impact on the styles of funds in which they are willing to invest. Choosing a fund with objectives aligned with the investor's objectives will help minimize wide discrepancies between what is ideal for the investor and what is actually delivered.

The next step is to combine this risk/return profile with any other constraints that the investor may have, such as liquidity requirements or tax considerations.

Step 2: Assemble Your Asset and Portfolio Allocations

Although this step is called portfolio allocation, it can also be looked at as an extension of determining the investor's investment objectives. This will help determine the appropriate style of funds from which the investor will choose. Given the investor's risk/return profile, the questions that should be asked revolve around how the allocation of capital to hedge funds will be used to enhance the investor's total portfolio.

Is the investment in hedge funds going to be used as a driver of returns and to achieve increased overall portfolio performance? As a way to smooth performance? As a hedging device primarily meant to offset risk and potential loss in other areas? Or perhaps a combination of the three?

The existence of many different fund styles offers investors flexibility in creating a portfolio of funds and other investments that may perform well in all market conditions. For instance, an investor could combine a short-biased hedge fund with a portfolio of predominantly long investments to act as a hedge against sharp drawdowns in the total portfolio and to help enhance performance.

Step 3: Understand the Different Strategies

You're now ready to decide on the types of funds that will best meet the investor's objectives and allocation strategies. The fundamental characteristics of the major styles can be grouped into four basic categories: equity; event driven (see page 113); relative value or arbitrage, and global macro.

The largest segment of the hedge fund universe is the equity strategies that follow similar guidelines to those set out by the inventor of the hedge fund, Alfred Winslow Jones. For the most part, these funds make directional investment and trading decisions based on fundamental and technical research, taking long positions in securities that are deemed to be strong or undervalued and taking offsetting short positions in weak or overvalued securities. A manager correctly using this type of hedging can create a portfolio that has an expected risk that is disproportionately reduced compared to the reduction that occurs in the expected return.

Returns in this category can vary widely and are oftentimes more correlated with stocks than the other strategies. However, since most equity strategies employ some sort of hedging, their expected volatility and maximum drawdown are much lower than the general market.

Event driven strategies invest based on corporate finance events such as mergers, bankruptcies, or lawsuits. Rather than looking at an investment from a traditional fundamental or technical standpoint, managers in this sector generally have a specific event in mind that will act as a catalyst for gain at some point in the future. Since the fund is not actually making decisions based on broad market movements or trends, the correlation between stock market returns and the typical event driven fund's returns are usually low. Gains for the most part have been fairly consistent over the years.

Relative value or arbitrage funds attempt to completely hedge out market risk by coupling long and short positions together in two highly correlated securities. The basic goal is to capitalize on a market inefficiency that may occur between two similar markets or securities. These strategies are similar to many equity hedge fund strategies in that they take both long and short positions. However, they differ in that they attempt to be completely market-neutral with little or no directional bias. Different strategies employed in the category include risk arbitrage, convertible arbitrage, and fixed income arbitrage. The obvious benefit of this strategy is that the risk associated with market volatility and specific stock volatility is hedged out. When done correctly, this generates low-risk returns as a result of the positive spread, or alpha, between the two investments. Arbitrage strategies have generally produced consistent, moderate-sized returns with little correlation with stock markets.

Global macro funds look at global capital markets using a top-down approach to identify opportunities throughout the world. Using changes in the macroeconomic policies of countries around the globe as the catalyst for ideas, these funds make large, and often highly leveraged, speculative bets on the direction of markets. Although these funds often score huge gains compared to other hedge fund strategies, they can be difficult for the average hedge fund investor to participate in because of high minimum investment constraints and overcapacity. Historically, global macro strategies have produced high returns with little correlation with the stock markets, and high volatility.

Step 4: Selecting a Manager

Only after the first three steps are covered can you make an informed decision on which manager is right for your client. Several years ago, an investor had to know someone who was either a fund manager or who was invested in a hedge fund. This is no longer the case. There are many ways to find good managers, including such Web sites as www.hedgeworld.com and www.altvest.com; conferences run by organizations like MAR/Hedge and Opal Group; and consultants like Hennessee Group and Tremont Advisers.

Using the investment criteria laid out in the previous steps will narrow the universe of 6,000 or so hedge funds to a more manageable number. Next you should score the funds based on how well they fit your criteria. Call the managers that make it through this screening process and request more detailed information on their funds. Using this information, look at past performance and other key areas that will help you decide if their fund and strategy are right for you. In cases where the fund has little or no performance history, it will be even more important for you to understand the manager's strategy and philosophy for making money. Once you have selected some managers, set up interviews to further screen them for objectives that fit yours. One of the final steps is to make sure you know what you are agreeing to when signing off on the private placement memorandum and limited partnership agreement. This may require legal counsel.

Step 5: Monitor Your Investment

Monitoring an investment will vary widely, depending on the fund manager and the amount of time that you have to dedicate to this process. While full transparency most likely will be the exception, rather than the rule, many managers are starting to adopt different ways of conveying the information that investors require without compromising the performance of the fund. With this information in hand, ask yourself if your original objectives are still being met. Has the performance been up to par with your original expectations? Have your investment objectives changed at all? Do the reasons for your initial selection of the manager still hold true? On an annual basis, or when major discrepancies do arise, call or meet with the manager for a more complete checkup.

Hedge funds offer investors an exciting, dynamic investment opportunity. But investing in them requires extra, and even overwhelming, work. The five-step framework is a good way to get the work started.

Adam Stauffer is a hedge fund marketing specialist with Advent Software Inc.

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