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Of course, there’s nothing new about hedge funds. Their origins can be traced back to the 1940s when Alfred Jones, a former US diplomat, established what is generally considered to be the first hedge fund. It involved short selling of strongly overvalued stocks – in effect, selling equities the fund had borrowed in the hope that it could buy them back more cheaply once they had fallen in value – together with a holding of undervalued stocks. As a result, exposure to market movements was reduced and manager skill was highlighted.
This first hedge fund demonstrated many of the characteristics that later became common among hedge funds, including a limited partnership structure, performance-related fees and a sizeable chunk of Jones’s own money to manage.
Today, the global hedge fund market is worth in excess of $500bn and there are estimated to be as many as 3,000 hedge funds in existence3. Hedge funds come in many shapes and sizes, ranging from so-called ‘macro’ funds that take big bets on market movements to ‘market-neutral’ funds, which aim to insulate themselves against the effects of any stock market fluctuation, be they upwards or downwards.
But before they go any further, European investors interested in investing in hedge funds should ask themselves two fairly fundamental questions. One, do they believe in the ability of active managers to add value? And two, can they find a hedge fund manager whose process is transparent and whose risk controls are robust? If the answer to both these questions is yes, then they can proceed to the next stage, which is to select a hedge fund manager.
For those institutional investors that are new to hedge funds, some form of ‘fund of funds’ arrangement is probably the best approach, at least initially. Fund of funds consist of a number of different managers following the same or different strategies. This, so the theory goes, enables investors to diversify their risk because the managers should be little correlated with one another.
Fund of funds are run by managers who are experts in selecting and monitoring hedge funds. Consequently, they possess a level of research and market knowledge that is beyond the reach of most investors. They also enable individual investors to participate in funds whose minimum investment size would usually prevent them from investing in them individually. And there are administrative advantages of investing in a fund of funds arrangements as opposed to an individual fund. In short, the difficulties associated with choosing a single fund manager are driving many institutions down the fund of fund route.
Having decided to use a fund of fund approach, what type of investment strategy should an institution follow? One approach might be to use a market neutral fund of funds product where the fund of fund manager seeks to provide consistent returns while minimising volatility. However, the protection during negative market conditions comes at the cost of lower returns when markets are performing strongly. Despite this, market neutral funds are currently amongst the most popular hedge fund strategies in Europe, according to recent surveys4.
However, those institutions that choose to go down the fund of funds route need to exercise care in their choice of overall manager. The hedge fund industry is notorious for its lack of transparency and the difficulty of assessing the risks within the funds. Institutions therefore need to select a fund of funds manager that will carry out a rigorous due diligence exercise on the managers it selects. This would include regular face to face meetings with the fund managers, thorough monitoring of their portfolios and an in-depth knowledge of the risks associated with their different strategies.
To be fair, the number of institutions, particularly pension funds, investing in hedge funds is still very small. At the beginning of 1999, for example, the consulting firm Hedge Fund Research estimated that pension funds accounted for just 8.5% of hedge fund assets in the US and 3.5% in the rest of the world. However, this is likely to change as hedge fund usage becomes more common and the core/satellite approach, which incorporates hedge funds in its satellite layer, becomes more widely accepted. A fund of fund model that employs a market neutral strategy is just one way of making this process easier.
Peter Stanyer is a managing director and head of strategic asset allocation at Merrill Lynch Investment Managers
1 Ludgate Communications Survey
2, 3 MLIM estimate
4 Ludgate Communications Survey

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