Four Key Questions to Ask Before Making a Hedge Fund InvestmentAdvisor Perspectives
If you are thinking of investing in hedge funds, you’re likely spending a fair amount of time understanding the different investment strategies and their associated risk/return characteristics. While this is essential to your decision-making process, it is equally important to understand the operations and underlying economics of a fund – the associated fees and expenses charged by the fund, the fund manager and any third-party service providers, and how often can subscriptions or redemptions be made. These considerations may determine whether an investment is appropriate for an investor’s risk profile and investment objectives. The hedge fund world is complex and there is a lot to take into consideration.
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Before making a hedge fund investment, investors and their advisors should consider four key questions:
1. Where does a hedge fund fit in your overall portfolio?
Hedge fund strategies extend across all markets, from equities and bonds, to commodities, currencies, credit, and derivatives. They can be guided by fundamental research, or they may be driven by quantitative methods, which explore not only the value of individual assets, but also make use of statistical analysis to exploit trading patterns, sectoral trends, or the rise and fall of volatility, for example. Hedge fund managers have developed a wide range of investment strategies that target an equally diverse range of investment objectives, including return enhancement, risk mitigation, and capital preservation. When considering an allocation to hedge funds, it is important to develop an understanding of the strategy objectives and investment styles to determine how hedge funds can complement your existing portfolio and align with your overall investment goals.
2. Are you comfortable with the manager’s investment process and operations after completing due diligence?
It is critical to understand a manager’s investment strategy, process, structure, and the underlying drivers of the fund’s returns. Within each strategy, different managers take on different amounts of risk to achieve their individual return targets, leading to a wide range of prospective risk/return profiles. An investor should analyze the fund’s track record from a quantitative standpoint, checking to see how returns compare to those of suitable benchmarks and the level of risk that was taken to achieve those returns. This includes an assessment of how the strategy would be expected to perform under various market scenarios.
Investment due diligence, however, is only half of the equation. A separate part of the due diligence process is operational due diligence, which analyzes the management firm’s operational procedures and compliance/regulatory framework. Hedge funds are much more complex than mutual funds or other publicly traded investment types, and they engage with a variety of third-party service providers in the execution of their investment strategy. Operational due diligence is a continual process of evaluating the operational aspects of a hedge fund and verifying what is conveyed in a fund’s offering documents, audited financials, and reference checks before, and while, invested. Investors are looking for any red flags that would indicate an unnecessary risk. If a hedge fund does not pass operational due diligence checks, an investor should not invest or, if already invested, seek to resolve the issue or withdraw from the fund.
Read the full article here by Joseph Burns, Advisor Perspectives.