Solving the hedge fund manager selection dilemma

Please note: This document is intended for readers with a good understanding of investments. Hedge funds typically carry higher risks than mutual funds, including greater complexity, less transparency and lower liquidity. As such, hedge funds are suitable only for experienced investors. Past performance is never a guarantee of future performance, and you may get back less than you invested. 

Key points 

• Financial markets were extremely volatile in April, and traditional diversification was more difficult to achieve
• Investing in hedge funds might be one way to improve portfolio diversification, in a more thoughtful approach
• With finding the right hedge fund so tough, find out more about how to select the best manager for you in our latest white paper
• Given the difficulties of being able to invest in hedge funds for many people, doing so through private banks and wealth managers, that can also monitor performance and due diligence, may be one solution. 

It’s been a tough year for investors. Not least since the US administration unveiled wide-ranging tariffs in April, which subsequently led to turmoil in financial markets and unusual moves in equities, bonds and currencies. These market moves made it more difficult to protect portfolios using traditional strategies, with asset classes far more correlated than usual.  

Against this backdrop of geopolitical and economic uncertainty, investors may value other sources of differentiated portfolio returns in addition to regular bond and equity investments. 

So, where might they turn for a more diversified portfolio performance? Hedge fund strategies that have undergone detailed due-diligence could be one option, they offer a multi-pronged approach and are well versed in investing across various asset classes and economies.  

Roles which hedge funds can play  

Our first white paper, An introduction to hedge funds, discussed what hedge funds are, and why they might be a useful allocation within a broader investment portfolio. In summary, hedge funds can play three distinct roles in an investment portfolio:  

• Equity/credit substitutes – aim to provide access to opportunity sets with specialist and highly experienced equity and/or credit managers with a definable investment universe and executing on strong thematic views. Often, these managers have higher correlation to equity and credit markets
• Risk mitigators – designed to offer portfolio protection during risk-off market regimes. In this category, a negative correlation to the MSCI World is expected (but not guaranteed) in deteriorating markets where market price moves are material. Performance depends on instrument selection  
• Diversifiers – typically provide steady returns with lower volatility and limited correlation to equity and bond markets. 

With as many as 55,000 hedge funds globally¹, choosing the right hedge fund for an investment portfolio can be a daunting process. Not least, given the wide-ranging performance dispersion seen between them (see chart). 

Hedge fund performance dispersion over the last 10 years

The dispersion between the 25th and 75th performance percentile for hedge funds, split by those categorised as being risk mitigators, equity/credit substitutes or as diversifiers  

Manager selection  

Given the wide difference in how different hedge fund strategies perform, picking the best accessible manager possible is critical, but far from straightforward. So, what steps can be taken to increase the chances of selecting the best manager for your needs? 

The first stage of the selection process begins with clarifying an investor’s needs, in terms of risk and return objectives, correlation properties and target investment time horizon. Once established, potential hedge fund candidates can be narrowed down to a shortlist of high-quality managers. Due diligence can then be carried out on them, encompassing both the manager and the hedge fund strategy.  

Due diligence 

In carrying out a more in-depth analysis of the short-listed managers, a due diligence process can be particularly helpful in trying to identify the best manager, while avoiding common pitfalls. Such a process should involve three areas:  

• Investment due diligence – focuses predominantly on the investment case of a hedge fund strategy, and typically includes analysing what  provides a strategy or a manager with an edge versus their competitors. This edge could come from the people involved in a hedge fund, the investment philosophy and process implemented, risk management framework, and whether the firm is well placed to support the long-term success of the strategy
• Quantitative due diligence – focuses predominantly on the performance characteristics of the manager and strategy, with the goal of understanding how a strategy aligns with the parameters of a search for a new hedge fund
• Operational due diligence – focuses predominantly on the operational factors, such as  a manager or strategy’s internal controls, operations and infrastructure in addition to their approach to their regulatory duties.   

Together, these three due diligence functions can help to identify candidates that appear most suited for an investor’s portfolio, and could bring fresh diversification and return attributes to help diversify portfolio performance.  

The process (see chart) can also highlight potential risks that could be posed by investing in the hedge funds. While risks can’t be eliminated, they can be better managed with the selection of the manager and an investor’s exposure to them.  

Once a hedge fund is selected, regular monitoring is integral to ensuring that the firm remains appropriate to the investor’s need and that its managers are not deviating from the original investment mandate they were given.

Hedge fund due diligence process

Illustration of self-fulfilling role that investment, quantitative and operational due diligence practices have in the process for selecting the right hedge fund manager

Gaining access to hedge funds  

One of the major issues for private investors is being able to obtain access to top-quality hedge funds, an area that is much less regulated than is the case for mutual funds. This means that many investors, without the relevant knowledge to understand the unique risks of hedge funds, may be excluded from investing in the asset class.  

In addition, minimum investment levels for high-quality hedge funds are typically above what typical private investors are able to allocate. As such, many investors have little exposure, if any, to hedge funds.  

Private banks can be a way through which to bridge some of the above gap. First, private banks can help to educate clients about hedge funds as an asset class, so the client can judge if they are suited to meeting their goals. Second, capital can be pooled from smaller investors to a level that surpasses the minimum ticket size for investing in a top-quality hedge fund. Third, and perhaps most obviously, private banks are well placed to conduct the relevant due diligence and ongoing manager monitoring.  

Find out more about how to select the right hedge fund manager, the wide range of performance dispersion among funds and get to the bottom of the key relevant investment risks in Hedge Fund Manager Selection: Why Due Diligence Matters. This is the second white paper in our series on hedge fund investing.