promise of hedge funds is alpha-above-market returns with lower risk.
For hedge fund managers, the ability to generate alpha converts to
significant personal wealth. In a recent study of 294 hedge fund
professionals, on average each manager created a net worth of $197
million due to his/her personal stake in a hedge fund management
company. Almost all, 89.8%, said being a hedge fund professional is a
way to become exceedingly wealthy and that it continues to be the road
to phenomenal personal wealth. This opportunity to "strike it rich" is
producing a boom in the number of hedge funds out there, with more that
8,000 and counting.
At the same time, the very wealthy are finding hedge funds increasingly attractive. In a survey of 312 affluent investors with a net worth of at least $35 million, 39.7% are presently investing in hedge funds (Exhibit 1). More telling is the fact that 63.5% of these affluent investors are very or extremely interested in investing in hedge funds over the next two years.
Given the tremendous financial reward potential in becoming a hedge fund manager, coupled with the very strong interest among the ultra-affluent in hedge funds, there is no question that the number of hedge funds from which to choose will only multiply in the future. While many excellent hedge funds are avail- able, many also should be avoided.
Hedge funds are private investment partnerships that often do not offer transparency. The lack of transparency is driven by the nature of the business-a need to safeguard proprietary money-making strategies. When the selection process is executed correctly, hedge fund investments can produce superior returns that are often uncorrelated to traditional markets, with relatively low volatility, meaning high returns with lower risk and fluctuation.
During the hedge fund selection process, two types of broadly defined risks should be considered-portfolio risk and firm risk. Portfolio risk is the easier of the two to evaluate, so we will start there.
Here we assess the investment portfolio through traditional statistical analysis such as standard deviation, correlation with benchmarks, Sharpe ratio (excess return above the risk-free rate per unit of risk exposure) and alpha generation (return above benchmark indices). It's helpful to compare the statistics of one hedge fund with other funds employing similar strategies. This exercise will highlight any anomalies and show how the manager sizes up against relevant competition.
Expect different returns for different asset classes and risk profiles. Remember to ask: "Do these returns make sense?" If a fund posted a 50% return while the benchmark did 10% in the same period, find out if the fund is taking unnecessary risk or straying from the stated investment strategy. An important consideration when selecting hedge funds for affluent investors is to make sure there is little or no investment strategy or "style" drift, which could potentially skew the overall risk profile of the entire portfolio.
A number of questions need to be asked and answered when evaluating a hedge fund portfolio. They include:
Does the firm/strategy employ leverage or utilize derivative strategies?
- If so, how and how much?
How concentrated are the holdings?
- A quick way to determine concentration is to look at the top 10 to 20 positions as a percentage of the total portfolio holdings.
How diversified is the portfolio from an industry and geographic perspective?
What is the risk management protocol of the hedge fund manager?
This list is far from all-inclusive, but is a great starting point. Dissection and review of the portfolio and manager is essential. When investing in hedge funds on behalf of the ultra-affluent, the "black box" or "trust me" approach from hedge fund managers is unacceptable. The ultra-affluent individuals are placing their trust in their advisors-sometimes blindly. Those advisors cannot do the same with the hedge funds managers they select.
More "intuitive" than evaluating portfolio risk is the risk of the hedge fund entity, or firm risk. The starting point is assessing the reputation and relationships of the hedge fund principals. Reputations and relationships provide insight into behavioral trends, treatment of investors, access to industry information flow as well as trustworthiness and professionalism. The backgrounds of principals can also grant insight into the ability of managers to successfully implement investment strategies.
Another simple but important question to ask: "Is the person who generated most of the track record still managing the fund?" This may seem rhetorical, but believe it or not, there are people out there trying to raise capital with track records generated by others who are no longer with the firm.
consider the firm's source of capital. In effect, how "hot" is the
funding? Are the monies really long-term committed, or will they
evaporate quickly with a performance glitch? Is the capital coming from
funds-of-funds, endowments, pensions, family offices or wealthy
individuals? Stability of capital base is critical, especially when a
fund encounters hard times. A swarm of hot-money investors demanding
redemption could exacerbate matters by forcing the fund to liquidate
positions to meet redemption needs. In addition to the composition of
the investor base, it's wise to consider the growth in the capital base
of the hedge fund over the last few years.
Experience is often the best teacher in determining if the hedge fund has staying power. But asking certain questions may reveal some helpful information. Are the foundations up- on which the firm is built stable? Explore operational matters such as the office structure, expansion of the management team and back-office support. Research the service providers employed by the hedge fund, such as auditors, lawyers, accountants and prime brokers.
alignment of interests is a key ingredient to any successful business,
and this also holds true for the hedge fund universe. Knowing the
compensation structure at the hedge fund may provide valuable insight.
Do the managers and team have proper incentives? Prepare to identify
any misalignment of interests (potential conflicts). Does management
have any outside investments? Does the firm have employee trading
restrictions to keep employees from acting on firm ideas?
When it comes to evaluating firm risk, referrals often prove useful, but they certainly cannot be taken as an absolute safe sign to invest. A comprehensive due diligence process is essential, especially if referrals are coming from sources with possible incentive/gain such as brokers, capital introductions professionals or third-party marketers.
Always obtain references, preferably from mutually acquainted parties. Contacting the prime brokers, lawyers, auditors, other investors, former employers and employees is another smart way to gather information. It may even be helpful to use a professional investigator to verify background details on key parties.
We provided a very brief overview of the two principal risks in choosing hedge funds for the ultra-affluent. We only touched upon the key issues in the selection process. Beyond the due diligence process discussed here, there's also the need to take into consideration the investor's tolerance for risk, any related personal considerations, as well as the overall asset allocation plan.
Selecting hedge funds is very much an art rather than science. In addition to verifying and understanding facts, statistics, figures and other qualitative facts, it's critical to feel comfortable with the hedge fund's managers. For instance, if it's difficult to get information, that's a red flag. Every investor has a right to ask questions and receive answers.
We look at hedge funds as living, breathing organisms that evolve over time. Remember, many things change: behavior, capital base, employees, strategy and so forth. To be successful investing in hedge funds for the ultra-affluent, you must keep up to date on the natural evolution of the firm. Remember to understand not just a hedge fund's history and statistics, but its dynamics and future direction.