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Despite last year's market turbulence, the hedge fund industry has proved its worth with favourable returns in comparison to traditional investments. Hedge funds are non-correlated with these investments, as has been proven in both theory and practice.
Any institutional investments are guided by the existing investment framework set by its board of trustees and by the varying European regulations. Many country regulations prevent institutions from investing in offshore funds (as most hedge funds are) while converselyprohibiting the creation of onshore vehicles - with the exception of Switzerland . Many institutions, such as those in the US, invest in hedge funds because they meet a requirement for a long-term investment that can enhance re-turns. Institutional return expectations are increasing due to the de-mand to beat existing portfolio benchmarks and the belief that glo-bal stock markets are over-valued.
The three main hedge fund investment strategies favoured by institutions are: p Market-neutral or relative-value: This involves managers endeavouring to isolate alpha and target a beta of zero. This is done by identifying and exploiting pricing inefficiences between related instruments, or combinations of instruments.
Market risk is decreased by balancing long short exposures to systematic risks.
p Fixed income arbitrage: This seeks to take advantage of pricing anomalies within and across global fixed income markets and their derivative products, using leverage to increase returns.
p Market-neutral long/short equity strategies: These all require the creation and management of long/short portfolios of common stock, with the goal of creating alpha, which is uncorrelated to the overall equity market.
As with any other investment, the institution must fully understand the strategy. This includes the underlying investment areas, which the investor must ensure complement his existing portfolio; the manager's investment style; how the strategy can be affected through increased money under management, and liquidity. The investor should also understand how the fund is hedged. The term hedge funds" can be misleading. Either a fund is hedged (it is equally long and short), or it is a hedging tool (short selling).
We strongly recommend the use of consultants with expertise in hedge fund selection and investment. Another option is the use of bespoke structured products, designed specifically for the institution's portfolio requirements.
Thorough due diligence should be undertaken prior to investing and, importantly, it should continue throughout the relationship.
Consultants and fund of funds managers will have an established due diligence process that can be used to great effect by institutions considering hedge funds for the first time. These experts will then continue the due diligence throughout the investment relationship. Only regular checking can ensure that the manager is adhering to the agreed strategy limits. This is very important. If the strategy was complementing the institution's existing portfolio when initially invested into, any variance could greatly increase downside risk.
There are three hedge fund investment structures: p Single manager hedge fund: where the investor will deal directly with the fund manager. With more focused strategies, they have the potential to outperform multi-strategy funds although their annual or monthly volatility may also be higher.
p Multi-manager hedge funds: where the fund is managed via separate accounts. The investor can benefit from daily reporting and daily risk monitoring and, with diversification across a number of strategies, risk can be reduced. p Multi-manager hedge funds/ fund of funds: where an investment is made into a fund which then invests into other funds across varying strategies. Overall risk reduction, diversification and entry into otherwise closed funds can be benefits.
If investing directly into a hedge fund, the institution should ensure that the manager is registered with the appropriate regulatory body and obtain full background on all principals. Many institutions require a minimum track record of three years and it should be made clear that this relates to actual trading. Also, the investor needs to be aware of lock-in periods, which vary greatly between funds. Fees average 1-2% management fee and 15-20% performance fee on all positive returns, taken annually. Fees inevitably are higher with increased consulting layers, such as with the use of a fund of funds manager.
Existing institutional investors recommend that all available risk measuring techniques should be analysed. Also, as highlighted by events last year, leverage is an important issue. The majority of hedge funds use between zero and four times leverage. The institution should ensure that it is aware of the leverage used and understands the implications of the effects of the leverage in varying market conditions. Transparency is an important issue, as was highlighted in events of August/September 1998. The underlying investments of each hedge fund strategy should complement the existing institutional portfolio and the investor should be aware at all times of positions held and fund volatility. With between 3,000 and 5,000 hedge funds in existence, institutions can afford to be choosy. If transparency requirements are not met, look elsewhere. Awareness of the companies used externally by the manager and what specific controls they apply is important. These include the fund administrator (who reports back to the investor), the prime broker (who provides leverage and stock lending) and independent risk monitor.
Sohail Jaffer is chairman of the Alternative Investment Management Association (AIMA)"

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