There are over 8,000 hedge funds today, and most claim to have a unique edge over the rest. Further, they are scattered among a myriad of strategies and substrategies—all with very different risk and return profiles that profit during varying market conditions. For example, long/short equity funds are very liquid and target absolute performance irrespective of stock market direction, by going both long and short shares. In contrast, event-driven strategies are more catalyst-driven, focusing on changing corporate structures, mergers and acquisitions, and distressed investing. Arbitrage funds might exploit perceived pricing anomalies to eke out small, steady gains, while strong commodity, currency, and interest rate trends could be harvested by momentum-driven strategies such as those used by CTAs (commodity trading advisers) and global funds. There is no shortage of managers playing across different financial instruments, different sectors, and different geographies—all with their own unique traits, opportunities, and risks.
It’s a daunting prospect for any investor looking to pick the right funds, and the two key questions in any due diligence process are:
How does the fund make its money?
Why does the fund make its money?
It may seem almost facile, but true outperformance and differentiation from the crowd comes from identifying trading talent and potential, and knowing how to time those investments.
To answer the first question, you need to understand and document the hedge fund’s basic investment strategy and trading style. What markets does the manager operate in, and what instruments are used? What are the potential returns, and what is the downside if someone makes the wrong call? What is the outlook given today’s markets?
Finding a strategy that matches your investment needs and risk appetite is important. Changing market conditions favor different instruments and strategies. For example, CTAs invest in listed financial and commodity markets as well as in currency markets through options and futures, giving them a wide and often highly liquid market. They are highly directional as they pick trends in momentum-driven markets, and can also lose significantly when these suddenly reverse.
The strategy also needs to sit well within your broader portfolio and balance sheet. For example, despite their volatility, CTAs can be a valuable addition to a broadly diversified portfolio, providing stability and an often rare stream of positive returns at times of negative market stress. Equally, if a company is involved in the energy sector, it is unlikely to want to invest in a long/short equity hedge fund specializing in natural resources.