While most of the investment community considers hedge funds to be “alternative” investments, we view them as having more flexibility when compared to their mutual fund peers, which are essentially confined to being long an asset or holding cash. At the core, hedge funds invest in the same traditional assets, generally stocks and bonds, but they have a much larger range of capabilities at their disposal to implement their investment strategies. Hedge funds can invest both long and short. They can access the derivatives and futures markets to gain (or reduce) desired exposures, and since they are not typically tied to a traditional benchmark, they have the flexibility to avoid entire market sectors or regions when opportunities don’t exist. Given their versatility, hedge funds have historically exhibited low correlation to traditional markets while mitigating the associated volatility, thus providing true diversification benefits within a portfolio. In addition to diversification, the pursuit of absolute returns and focus on reducing drawdowns during difficult market environments have led hedge funds to generate excess returns, or alpha, over time.
Understanding the benefits of investing in hedge funds and actually achieving the desired results is contingent upon an investor’s ability to select top-tier managers. Hedge fund manager selection is much more important than selecting traditional stock and bond managers, as the difference between top- and bottom-quartile returns can be thousands of basis points depending on the strategy. Hedge fund strategies include, but are not limited to, long-short equity, merger arbitrage, global macro and systematic trading. When analyzing strategies, another important aspect of investing in hedge funds is the portfolio construction process. Not only do you need to select the right managers and strategies to achieve your desired results, but the way you put those puzzle pieces together to form a portfolio is critical, and an often-overlooked step in the investment process. Ensuring proper strategy diversification, selecting top-tier managers within those strategies, and sizing each of those elements appropriately will determine whether or not a hedge fund investor is capable of achieving their investment objectives.
