Other clues to alignment of interests are hurdle rates and clawbacks.  Hurdle rates prevent fund managers from receiving performance fees on any gains they make unless they exceed a certain threshold, such as the ten-year T-Bill rate, or a certain percentage (e.g., 5%), although they still receive their basic management fees regardless of whether the fund exceeds the hurdle.  Clawback provisions in contracts allow investors to recover performance-based compensation if future events demonstrate that managers received excessive or unearned profits through, for example, manipulation of financial results.  

Because of the complexity and opacity of hedge funds and their strategies, industry experts recommend outsourcing the hedge fund selection process to qualified professionals. "There's a very specific and intense effort that has to occur on research, sourcing and due diligence.  It takes a team and a dedicated focus to do properly," says Lenahan.

Advisors should look for experts whose screening process includes filtering information from high-quality, proprietary databases and ensuring that funds are following operational best practices-a key component in minimizing fraud risk. Interviewing managers, performing background checks and site visits, verifying relationships with prime brokers and with outside legal and accounting firms and reviewing all relevant legal and financial documents should also be part of the process.

Alternative Hedges
John Osterweis, chairman and CIO of San Francisco-based Osterweis Capital Management, thinks many individual hedge funds add value, but that there are also many that do not. A lot of hedge funds don't hedge effectively, he adds.
Advisors don't necessarily need exotic strategies, with their accompanying high fees and low transparency, he says.

Osterweis, for example, prefers to use fixed income as a hedge against downside risk, to decrease volatility and to provide income for his clients' portfolios. He runs what he calls "a very simple, dynamically balanced fund," the Osterweis Strategic Investment Fund.  He varies the ratio of stocks and bonds in the portfolio by up to 75% stocks, 25% bonds, or vice versa, according to anticipated market conditions.

Osterweis says that over long time periods, "the old 60/40-60% stocks, 40% high-grade bonds-was in fact a pretty good hedged book. In any serious bear market, the high-grade fixed income produced a positive return because of the flight to quality. If there's another melt-down in the stock market, investment-grade bonds are going to do a heck of a lot better than stocks."

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