Hedge funds are pools of investment capital that have the flexibility to employ a vast range of trading strategies in both traditional and non-traditional markets. Because of this versatility, hedge funds can bring diversification to a portfolio that is hard to find elsewhere.
How are hedge funds different
Creating a truly efficient portfolio relies on bringing together investments that respond to market events differently. Hedge funds can enhance diversification in the following ways:
- A broad opportunity set and fewer restrictions on investments allow more opportunities to discover investments that are less correlated.
- Less dependence on market direction, which can help to minimize volatility.
- Trading strategies that seek out market inefficiencies, allowing highly skilled managers to add significant value over time.
Finding a good match
Hedge funds rely more heavily on manager skill than broad market movements to generate returns. As a result, performance can vary widely. Choosing a manager based on their past track record is a given, but there are other factors to consider:
- Investment objective. What are you trying to achieve with this investment? Lower volatility? Enhanced return? Decreased correlation?
- Structure. Will you design your own allocation or do you want a fund of funds to manage the allocation for you?
- Team. What is the management team’s makeup, experience and culture?
- Risk management. Is risk management an independent function that provides necessary checks and balances?
- Operations. Does the fund have a sound operational infrastructure backed by dedicated support groups to allow the investment team to focus solely on investing?
What’s in a name?
In our view, there are five main categories of hedge funds:
- Long/Short. Involves buying and/or selling equity or credit securities believed to be significantly under- or over-priced by the market.
- Managed futures. Invests in global futures markets, taking long and short positions in assets such as agricultural products or precious metals.
- Global macro. Seeks to profit from broad directional changes in securities markets, interest rates, exchange rates and commodity prices.
- Distressed. Purchases securities of companies that are going through restructuring and looks to profit from those securities once restructuring is complete.
- Multi-Strategy. Maintains flexibility to invest in multiple strategies at a given time.
