Posts Tagged ‘Operational Due Diligence’

Where is the Alpha in the Hedge Fund Marketplace?

Wednesday, May 21st, 2008

In my May 7th Blog, entitled “What is a Hedge Fund?,”  I discussed a recent Hedge Fund conference that I attended, where one of the panels of large experience Institutional Investors discussed the reasons they invested in Hedge Funds.  The majority of the panel responded by saying, “To achieve Alpha for their overall portfolio.” 

I would agree with this comment and state that most investors use Hedge Funds to gain Alpha for their portfolio especially alpha uncorrelated to the market and for diversification purposes.  If the main reason to invest in Hedge Fund is to create Alpha then which Hedge Fund strategies should you invest in?

Although there is not a perfect answer to this question and honestly the answer probably changes on a regular basis depending on the market, I would make the comment that you should look at investing into strategy/sector specific funds or more importantly into funds with track records of less then three years.  Being this focused does raise your investment risk level but with this risk comes a significant raise in your reward potential.

Recently, there have been numerous articles that would agree with this belief and there have been studies in the past which show that the typical Hedge Fund’s best returns are early in the fund’s life, when the fund’s are not managing large sums of money and conviction on the part of the fund in their investment ideas is high. 

Many investors would state that the real risk with these smaller funds is operational in nature and that is why it is important to perform Operational Due Diligence on these funds when performing your Due Diligence. In many cases these funds rely on outside vendors to support them in the business and therefore it is important to understand who their vendors are, and perform your due diligence on the vendors as well.

In regards to the large Hedge Fund ($1 billion in size as a general guideline) with a broad investment focus it is significantly harder getting performance, especially in market capitalizations which have become less efficient over the past few years such as large cap stocks. This does not mean it is impossible, but very few accomplish this task on a yearly basis.

Large funds can use their capital to become a voice or an activist with some of their holdings and in return the Hedge Funds goal is to increase the value of those holdings but this is a specific strategy and hence would fall into the category where we believe you can achieve Alpha. As well, large sector focused long/short funds or large geographically focused long/short funds would fall into the category of Alpha producing category.

Therefore I am not saying to not invest in large Hedge Funds, for there are many good large Hedge Funds, but if you take an overview of the entire market and you had a higher risk appetite or desire to really gain Alpha for your portfolio then you should look into smaller asset sized funds.  Your risk level will increase but so can your reward.

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