LIKE MOST investment decisions, investing in hedge funds is a rational process that begins with an investment goal and results in making one or more investment selections. The process is designed to improve the chances of achieving a set of investment objectives. It is important to follow a methodology in constructing a portfolio of hedge funds: to create a framework within which to select investments and to evaluate and monitor the portfolio’s risk and performance. Such a framework provides an efficient information feedback loop that allows the adjustment, refinement, and successful management of a multiple fund or manager investment portfolio.

Although alternative investment strategies are dissimilar in some ways to more traditional investments, the fundamentals of prudent investing still apply. Decisions to invest in these strategies must be based on realistic goals and expectations. To establish realistic goals, investors must have an understanding of the available return characteristics of the main hedge fund strategies. The first fourteen chapters of this book present an overview of a variety of investment approaches and methods of investing that will help investors understand hedge fund opportunities and formulate realistic goals.

The first step that an investor should take is to define the objectives of the portfolio. The objectives make explicit what the investor expects to achieve from the hedge fund investment. These usually include return and risk measures over the time frame of the investment, such as target return, consistency, volatility, maximum loss, and correlation to stocks or bonds. Other objectives might address leverage (both borrowing and derived), liquidity of the investment, and region and country exposures. Structural issues pertaining to custody of the assets and fund transparency are also important considerations when establishing objectives. Although almost all investors share achieving investment returns (either absolute or relative to some benchmark) as a main objective, investors may have one or more objectives of differing priorities, ranging from pursuing risk-adjusted return to accessing specific types of financial instruments or investment strategies. FIGURE 15.1 illustrates an example of a possible set of portfolio objectives.

Whereas portfolio objectives make explicit what investors wish to achieve through a hedge fund investment, investment parameters help to control how those portfolio objectives are accomplished. They include the rules and guidelines that determine how an investment portfolio is constructed and operated. Parameters are the constraints, requirements, inclusions, and exclusions imposed on the investor’s selection of hedge fund structures and strategies and the operation of the investment program. These can be self-imposed by investors or required by regulatory bodies.

The investment parameters for individual fund managers may differ considerably from those of the portfolio as a whole. For example, the volatility of returns allowable for any particular hedge fund in the portfolio might be greater than the return volatility objectives of the total portfolio because of the offsetting nature of the volatility of noncorrelated strategies (see Figure 15.2). By diversifying the portfolio across these various funds, the portfolio manager reduces the return volatility of the portfolio as a whole.

Risk at the manager, strategy, and portfolio levels should be addressed in the investment parameters. One of the main reasons for establishing investment parameters is to manage or avoid existing and potential investment risks. Investment risk can take many forms, including:

By diversifying portfolios across strategies and financial instruments, the overall portfolio risk is reduced by limiting the effect that any one exposure can have on the portfolio as a whole. A primary goal of fund diversification is to include funds in the portfolio that will perform well in different market environments. This is accomplished by combining a variety of strategies. Funds that use the same strategies will often perform similarly to one another. For example, a portfolio of ten fixed-income arbitrage hedge funds will not reduce risk significantly when each allocation represents a similar investment idea. A portfolio with few limiting parameters allows for broad diversification across strategies and instruments. Keep in mind that parameters that attempt to screen out risk may also narrow the universe of acceptable strategies or hedge funds. With fewer acceptable funds to choose from, the final portfolio may be less diversified. In this case, the investor has effectively traded one kind of risk for another. If the investment parameters limit the scope of the portfolio, diversification should be focused on the eligible approaches and number of acceptable strategies.

The optimal number of hedge funds to include in a portfolio is the subject of some debate. Expert opinions recommend from five to fifty. Of course, the number of funds included is often determined by the amount of investment capital and the desired form of investment. Because larger and more established hedge funds have higher minimum investment requirements, fewer of these funds can be included in a portfolio compared with funds that require lower minimum investments. If separate accounts are used, the minimum investment amount per manager will usually be significantly larger than those required for investing in comingled funds.

The selection process applies the investment parameters to the construction of the portfolio. It begins with the identification of acceptable investment structures. Once an appropriate structure is chosen, the next step is to select strategies.

Choose an investment structure based on its ability to satisfy the investment parameters and objectives. Hedge fund structures and investment vehicles are covered in detail in Chapter 2, but some critical points are worth reviewing here.

A large portion of this book (Chapters 3 to 14) is devoted to a discussion of the various hedge fund strategies. They represent a broad range of risk and return characteristics. Even within strategy classifications, there is distinct variation. Strategies should be selected based on a reasonable expectation that they will:

Although the large number and diversity of hedge funds that must be analyzed may seem daunting, identifying the structure and strategies that are acceptable focuses the choice of possible funds and managers. Parameters—such as amount of assets under management, experience of the fund manager, performance, and instruments traded—reduce the field of candidates further, resulting in a short list that can be analyzed more thoroughly. A closer inspection of the managers—even those who describe their strategies similarly—will reveal variations and nuances in style and specialization. Managers who practice similar strategies do not necessarily have the same talent for doing so. However, comparing managers’ performance numbers can be problematic because a particular manager’s performance numbers may, on closer inspection, be revealed to be an amalgam of inconsistent investment approaches implemented over time. Investment managers’ promotional materials and disclosure documents can be helpful, but in many cases these are written in such broad terms that their usefulness is limited. The need for transparency for prudent investing begins at this stage. By reconciling the performance record to the underlying exposures held as a consideration of the market conditions at the time allows a much more complete understanding of a manger’s investment activities and the associated benefits and risks.

• Quantitative analysis. Quantitative analysis is the statistical evaluation of the past performance and investment activity of hedge funds and separate accounts. This process involves gathering and analyzing such data using various measures of risk, reward, and risk-reward relationships. Analysis of risk and performance statistics also allows investors to compare one investment with another or with peer groups and benchmarks.

• Qualitative analysis. Qualitative analysis looks behind the performance numbers at how they were achieved, who the firm’s principle individuals are, and what the make up of their business is. Qualitative analysis is critical in evaluating a fund manager’s historic performance. If a fund manager’s past performance is to be of any use in predicting future performance, then there must be continuity. Thorough qualitative evaluations take into account past and current market conditions, the latent risks and benefits of the strategy, the consistency of the fund manager’s investment operation over time, and the strengths and weaknesses of the individuals making investment decisions.

• Summary. Because an investment in a hedge fund is an investment in an entrepreneurial business operation, investors should seek to answer the question: What business is the manager really in? The various areas of the business that should be reviewed include operations, personnel backgrounds, investment methodology, and performance record.

In reviewing the operation of the business, assess the various aspects of the business’s internal functions, including management, trading, research, operations, compliance, and client service. Outside professionals—such as the firm’s accountant, auditor, attorney, prime broker, bank, administrator, and custodian—should be evaluated as well. In addition, the information systems on which a firm relies—including trading, back office, and research systems—should be considered. Also address contingency plans for backing up the information systems and the existence of an alternative operating location to maintain continuity of portfolio management in the event of a crisis.

Before investing in a hedge fund, there are questions that should be answered, including: What is the regulatory history of key personnel? Have any of them led any “past lives” as investment managers, requiring further investigation? Where is their money invested? What do references and background checks reveal about them? Registrations with the Securities and Exchange Commission, Commodities Futures Trading Commission, National Association of Securities Dealers, and National Futures Association are important information sources. Check with such agencies to learn more about the manager’s regulatory history. The answers to these background questions give an investor a clearer idea of who the fund manager is and help indicate what actions can be expected in the future.

Even managers who use similar strategies may implement those strategies in different ways. Therefore, it is important to learn as much as possible about a manager’s investment methodology. Many of these considerations are discussed in the Core Strategy and Investment Process sections of the strategy chapters in this book. Each manager should be able to describe all material aspects of her investment activities including: the fund’s sources of expected return; use of leverage; liquidity; diversification; position concentrations; portfolio turnover; methods for evaluating securities; research sources; investment universe; use of derivatives and short selling; hedging practices; significant risks; and risk-control procedures. Determine the factors that influence decisions to put positions on and take them off and how the actual trading is accomplished as well as whether the fund’s investment methodology has changed over time. The most consistent funds usually have well-refined and tested investment methodologies. On top of these basics, investors should find out who makes the fund’s investment decisions, and what the contingency plan is to safeguard the portfolio if a key individual becomes incapacitated. In sum, it is important to examine the process that a fund goes through to arrive at its final investment decisions as well as how, mechanically, the investments are made.

The first thing that most investors will look at is a fund’s performance record. However, prudent investors should not take that record at face value. They will examine how the performance record reflects past and current market conditions. They will note that managers with longer track records tend to be more established and to have dealt with a wider variety of market situations. On the other hand, each year managers with long, stable track records run into difficulties and post significant losses.