It is the use of these strategies that is the fulcrum for understanding the majority of hedge fund successes. The principle underlying hedge fund management is that there are inefficiencies in the capital markets at all times. These pricing inefficiencies are caused by a myriad of catalysts. For example, risk arbitrage is a commonly employed strategy that seeks to capitalize on the price fluctuations in stocks and bonds caused by corporate events such as mergers, acquisitions, spin-offs and recapitalizations. In a classic example of a merger (risk) arbitrage trade, the hedge fund manager takes a long position in the stock of the target company, and simultaneously takes a short position in the stock of the purchasing company (merger arbitrage hedge fund managers generally only take these positions after the announcement of these events, rather than speculating on corporate M&A activity). This trade is employed (typically on a leveraged basis) in an attempt to realize the price differential between the prices paid for the securities of the company involved in the acquisition and the anticipated value to be received for the securities upon consummation of the proposed transaction.

The hedge fund manager in this example is taking offsetting long and short positions, thereby decreasing the amount of systemic risk to which he exposes his or her fund. Furthermore, when assets are managed this way, the risk is placed on the completion of the transaction and not the direction of the market. Successful hedge fund tactics create a risk trade-off. While investing in traditional long-only investments, the risk taken on by the investor is full market, or systemic risk. Hedge fund investing, on the other hand, trades away market risk and assumes the risk of being able to successfully execute his or her strategy.

Active Management Tools

Due to their legal structure, hedge fund managers can outperform traditional managers because they have more active management tools at their disposal. Even those who do not pursue risk arbitrage strategies like the one discussed above have the ability to short stocks, utilize leverage and go to cash in times of market turbulence. Traditional managers have greater constraints as a result of mutual fund industry rules imposed by Congress and the Securities and Exchange Commission (SEC).

For smaller public investors, such rules serve the very important public goal of reducing the "buyer beware" concerns inherent in investing. By limiting the scope of managerial discretion and requiring positional transparency (albeit time delayed), the public has a better sense of exactly what product it is buying. For professional investment advisors with sophisticated, wealthy and experienced investor-clients, however, the legal structure of traditional funds must be recognized for the trade-off they represent. A traditional manager has fewer active management tools available and thus less ability to exploit market inefficiencies.

Downside Protection

Due to the flexibility of hedge funds to take short positions or to go to cash during times of market turbulence, many hedge funds outperform traditional investments when the market turns negative. This fact has a lasting benefit as it often takes equity and debt markets months, if not years, to recover from market collapses. The chart on the next page reflects this phenomenon.

Fund Of Funds Benefits

Once convinced of the merits of hedge fund investing, the question is how to proceed responsibly. For those investment advisors either new to hedge fund investing or with smaller increments of capital to invest, a fund of hedge funds may be appropriate. Although funds of funds have an additional layer of fees, they also offer due diligence expertise, access to exclusive and/or closed managers and lower investment minimums.

There are a number of factors that should be considered when selecting a fund of funds. A couple of obvious requirements are a competitive track record as measured against other funds of funds and the manager's ability to demonstrate a repeatable, formal due diligence process in selecting and monitoring subfunds. An effective due diligence process should include quantitative and qualitative screens to scan the universe of hedge funds, as well as the ability to stress test a proposed allocation of funds to various market conditions. This back testing will help to predict the performance of a fund of funds during periods of duress, such as September 11, 2001, or the Russian bond crisis of August 1998.

Delving a bit deeper into a fund of funds manager's due diligence process, one may also want to consider the ability of the manager to identify smaller, often newer entrants to the hedge fund space. It is commonly accepted that performance on the fund of funds level deteriorates as its underlying funds get too large. Studies strongly suggest that larger funds of funds underperform smaller ones. Brian C. Ziv of Guidance Capital suggests that funds of funds between $100 million and $500 million perform approximately +2% better annually than funds larger than $1billion. To quote him directly, "As a rule, large size [of hedge funds] is an enemy of performance. But size is a more severe problem for hedge funds and funds-of-funds than it is for traditional managers (Selecting Funds of Funds Guidance Capital, 2002)."

Another recently popular choice among advisors is the SEC registered fund of funds. These funds offer some significant benefits when compared to unregistered funds of funds, such as periodic disclosing of positions and significantly lower investment minimums. However, when comparing registered funds of funds with unregistered funds of funds, some other considerations are in order. First, registered funds of funds do not offer the same level of flexibility as their unregistered counterparts-registered funds need to invest with larger hedge funds. This creates a lost opportunity to invest with undiscovered managers, which often provide the best returns. Second, registered funds of funds must invest only with those hedge fund managers willing to give full transparency, which by definition reduces the universe of hedge funds to which it can allocate money. Third, many of the regulatory oversight benefits offered by a registered fund of funds can be achieved by investing in an unregistered fund managed by an SEC registered (and well capitalized) investment advisory firm. Finally, the majority of registered funds of funds do not charge a performance fee, but rather a comparatively larger annual management fee. This fee structure removes a basic principle of hedge fund investing: that managers should take a performance fee in order to align investors' interests with their own.

Survivorship Bias

While the benefits of hedge fund investing are significant, the concept of survivorship bias should be considered when accounting for the overall performance of the hedge fund universe. Survivorship bias is the exclusion of investment managers that no longer exist in data samples such as indexes. On many occasions, hedge fund managers simply cease operations because of poor performance or because net outflows of assets erode economies of scale. Some estimates claim as many as 25% of all new hedge funds fold after one or two bad years. Their exclusion skews the performance of various hedge fund indexes. Because of this bias, it may be difficult to accurately assess the overall performance of the universe of hedge fund managers. It is estimated by some that survivorship bias accounts for 3% of performance per year, but even when accounting for this bias, studies show that the average hedge fund outperformed the average mutual fund, but with less risk (Alexander Ineichen, Absolute Returns: The Risk and Opportunity in Hedge Fund Investing, John Wiley & Sons, 2003).