Direct Investment in Hedge Funds Poses Challenges

(July 5, 2012) —Fund of funds may not offer the cheapest way to invest in hedge funds, but direct investments bring their share of headaches as well.

Institutional investors looking to directly invest in hedge funds must fully understand the four principal hedge fund strategies—and appreciate how they differ in their effect on portfolio diversification—if they are to do the job correctly, a paper by consultancy bfinance asserts.

“It is clear that some types of hedge funds generate returns that partly derive from the direction of underlying markets,” the paper contends. “So given the expense, it makes sense to restrict one’s hedge fund investments to areas where a similar return cannot be achieved elsewhere if pure diversification is needed. However, the full range of hedge fund strategies can benefit a broader portfolio if investment is aimed at return enhancement.”

The paper breaks down hedge fund strategies into four buckets: equity long/short, relative value, event driven, and trading. According to bfinance, equity long/short is the process of buying undervalued stocks and shorting those that are overvalued. Relative value centers on arbitraging across many different asset classes. Hedge funds using event driven-strategies seek to exploit market inefficiencies surrounding events like mergers or defaults. Finally, trading strategies are quantitatively driven, focusing on following trends and analyzing the global macro area.

For institutional investors interested in moving away from fund of funds into direct hedge fund investment, bfinance recommends a cautious approach. A gradual transition, in which an investor both continues to allocate to fund of funds and tries out a few direct investments, is the best place to start. “Complementing a portfolio with targeted direct hedge fund investment enables better risk budget management, the potential for lower fee negotiation, transparency in the selection process and the underlying portfolio, better diversification, ownership of the assets and currency management,” the paper argues.

The size of the hedge fund mandate is also important for how an institutional investor should look at direct investments. While mandates under $50 million are advised to stick with fund of funds, those between $50 and $200 million should implement a hybrid approach. Mandates over $200 million, the paper says, are large enough to allocate to hedge funds directly, though a consultant should advise on such transactions.

“In summary, moving from fund of hedge funds to direct investment is a big step,” the paper concludes. “But by taking some capital from your fund of hedge fund investments and applying it to the most diversifying strategies such as trading (macro and CTA), an investor can plug gaps in his existing portfolio while keeping options open if things go wrong. By measuring the impact of direct investment on the broader portfolio, rather than in terms of standalone track record, asset owners will be able to gauge the complementary and diversifying benefits of direct investment.”

To see the bfinance paper, click here.