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Hedge funds are flexible, absolute return vehicles that typically invest both on a long and short basis in a variety of listed and over-the-counter securities. Once the exclusive realm of private investors, hedge funds are attracting more interest from pension plans, endowments and other institutions. This trend has exploded most recently as fiduciaries realise the diversification benefits of both hedge funds and other alternative investments.
One benefit of the hedge fund structure is that it attracts many talented investment professionals. This is because they are permitted to earn an incentive fee, usually 20% of annual gross profits.
Prudent hedge fund investments can provide a better risk-reward than traditional asset classes. However, it is of paramount importance that one has the correct expectations of what hedge funds have to offer.
Hedge funds are not risk free, but rather offer the investor a set of risk parameters that differs from that of traditional investments. There will be times when long-only products outperform hedge funds.
Hedge funds are not liquid investments. Therefore one has to perform solid due diligence and manager research prior to investing.
All hedge funds have the potential to contain equity-like risk. They are equity diversifiers, not a substitute for conservative fixed-income. One should not invest in hedge funds on the basis that they will provide a consistent positive return every single month. This is not sustainable in the long run.
One should not invest in hedge funds simply as a refuge from the traditional markets. Rather one should try to understand the many positive attributes of hedge funds, in order to be comfortable with these investments irrespective of the fortunes or fluctuations of traditional debt and equity products.
All investors should have a clear manager selection process. This is easier said than done. While one will develop a sense as to what makes hedge funds succeed over time, it is quicker to understand what makes them fail. Therefore for those new to the area, an initial process of elimination methodology should assist in avoiding mistakes. Two areas of focus we will discuss here are, risk management from a portfolio and manager perspective; and red flags that assist in eliminating prospective investments from consideration.
When evaluating a prospective hedge fund investment, it is imperative to understand the underlying risk management principles on which the fund is run. Sound risk management combines both quantitative and qualitative aspects, blended with a dose of common sense. The following three points should allow the investor to gauge whether a candidate hedge fund manager truly adheres to sound risk principles, These are liquidity, leverage and counterparty risk.
q Liquidity: Before you get in, know when and how you can get out!
Prior to investing, one should have a clear idea of when and under what circumstances the investment should be harvested. One should also evaluate the possibility of not being able to liquidate the investment during periods of market stress. It is important to ensure that the underlying assets in a particular hedge fund are liquid enough to fulfil all obligations to investors. All hedge fund prospectuses have terms giving the investment manager the right to suspend the payment of redemption proceeds to investors in a number of loosely defined scenarios, regardless of the general liquidity terms offered.
One should try to understand the underlying liquidity of each asset class in which the manager invests. This is more difficult to ascertain for over-the-counter securities such as convertible bonds, mortgage-backed securities and high-yield debt. Nevertheless, one can gauge the relative liquidity of these securities from sell-side research.
q Leverage: ROA beats ROE.
Leverage is not always undesirable and, when used prudently, can be a useful way to enhance returns. With hedge funds, the problem arises when an excessive amount of leverage is used. For a given strategy, if two managers are able to generate similar returns, the manager who uses less leverage is preferable. One should look for return on assets (ROA) rather than returns on equity (ROE). According to the classic Du Pont analysis, the difference between ROA and ROE is financial leverage.
For each hedge fund asset class, one can determine maximum leverage boundaries. As a rule of thumb, regardless of strategy, the net exposure (long minus short) should be lower than 100% of investor capital. The higher the gross leverage (long plus short), the lower the net exposure should be.
q Counterparty Risk: Do not operate on a business plan that puts you at the mercy of others.
Counterparties include both debt and equity claims against the hedge fund. It is essential to determine that the portfolio manager really understands how these counterparties will behave during times of stress. Moreover, one should always ask what steps the manager has taken to mitigate and diversify counterparty risk. A hedge fund is a business, and should be run as such.
Hedge funds are flexible investment vehicles, which by design have the ability to provide attractive and usually superior risk adjusted returns relative to traditional asset classes. However, any horse is only as good as its jockey. One has to distinguish between truly talented managers, and those who do not have the ability to fully utilise the hedge fund structure profitably over the long run. The incentive fees that are ingrained in these products have always attracted all comers, be they talented or not.
We have attempted here to provide some tools to assist in successful differentiation. While the issues discussed here are by no means an exhaustive list, they may provide an initial framework on which to base an initial manager selection process.
Norman Chait is vice president at AIG Global Investment Corp in New York

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