If we naively apply this model to a portfolio that includes hedge funds, the allocation to the funds could be quite large: Hedge funds offer good diversification; they are typically uncorrelated with other asset classes; and historical data indicates their returns are relatively high while their risks are relatively low. Yet before we rush to embrace this seemingly remarkable investment class, experts counsel that there is more to hedge funds than meets the eye. “We don’t want to put our clients’ portfolios 60 or 70 percent into hedge funds,” says Douglas Allison, managing director of Beacon Pointe Advisors in Newport Beach, Calif. “It may appear to make sense, but I’m just not willing to risk my client’s money, because hedge funds have a number of inherent risks that do not show up in the data.”

The quality and completeness of the data is the weak link with hedge funds. Modern portfolio theory works well when we are dealing with traditional asset classes, such as equities or government bonds, which come with abundant historical performance data. The hedge fund market, however, is not nearly as transparent or well established. Only in recent years has real data on returns become available, and even then some question the reliability of this data. “The data is simply looking at the risk-weighted return, and even if you assume that that is correct, it ignores other aspects,” says Andrew Popper, a group chief investment officer with SG Hambros in London.

Several weaknesses plague hedge fund data. First, not all managers submit information to hedge fund databases. Managers of underperforming funds may not want to advertise the fact that they are not keeping up with their peers. Others, whose funds are successful but are perhaps closed to new investors, might also be shy of publicity because they simply do not need to advertise.



Meanwhile, the quality of the pricing information offered by the funds is often suspect. It is very difficult to effectively value many types of hedge fund positions, because the investments are illiquid, meaning they are not actively traded, and do not therefore have a market price. In these cases, managers or third-party appraisers must, essentially, guess at the value of the investments, based on comparable assets or complex financial models. (Click image to enlarge)

Popper notes that other factors, unique to hedge funds, put them beyond the purview of modern portfolio theory. Perhaps the most important is the fact that their performance is often not amenable to the type of statistical analysis that can be applied to other types of investments. The returns of hedge funds, unlike those of stocks or bonds, do not form the classical normal distribution (or bell curve) when plotted on a graph. “[Modern portfolio theory] only makes sense as long as the results of the investments are normally distributed, but there is a case to be made that the tails of the distribution for hedge funds are not normal,” Popper says. This means that the probability of an extreme event—say the collapse of an emerging market economy—severely disrupting a hedge fund is higher than the models suggest. Furthermore, optimization models used to decide on an allocation do not take account of the relative lack of liquidity of hedge fund investments—investors typically face a lock-up period of one to two years, whereas an investment in stock can usually be unwound at a moment’s notice.

Finally, there are several idiosyncratic problems that stem from the fact that hedge funds are typically managed by a small number of individuals and feature low levels of oversight and transparency. Hedge fund managers could change their investment strategy without informing investors, a fact that many overlook as they perform due diligence. “Typical due-diligence approaches focus on the investment capabilities of the fund itself—what its performance track record has been and how consistent that is,” says Ed Hawthorne, managing principal of New York-based hedge fund advisory company Capco. “But these approaches don’t go very far toward understanding the operations and controls of the enterprise and their ability to withstand shocks—there could be an operational error or an opportunity to misrepresent the fund.”

Optimize and Allocate
Because of these various hedge fund risks and data biases, our wealth advisors will typically err on the side of caution, and with good reason. When determining how much to invest, an advisor’s first step is to assess our risk and return objectives, as well as our spending needs and investment time horizon. “You have two kinds of high-net-worth hedge fund investors,” says Joelle Weiss, New York president of the Swiss private wealth management group Compagnie Bancaire Geneve (CBG) Investment Advisors. “You have the guy who is entrepreneurial and is always looking to be very aggressive. He uses hedge funds to really look after the 20 or 30 percent a year returns. These guys are more momentum driven; they are always looking to make the big buck. Then you have the high-net-worth guy who is enticed to hedge funds for the opposite reason: He can get a very steady return with very low volatility and actually still make Libor [a benchmark interest rate] plus 7 or 8 percent.”

The advisor’s next job is to run the optimization model while taking the various data biases and hedge fund risks into account. According to Popper, this is a subjective process, and a knowledgeable advisor generally makes a qualitative judgment and lowers the allocation to hedge funds accordingly. “If the model tells you that the hedge fund allocation should be 30 or 35 percent, as happens many times, in our view you have to temper that with the other judgments,” he says. “In our case we believe that around 15 percent is the right allocation.” Popper adds, however, that in bespoke cases SG Hambros will recommend a much higher allocation for clients with large sums to invest and the right risk appetite.

According to Beacon Pointe’s Allison, his firm will typically recommend about a 10 to 15 percent allocation, with a maximum of around 25 percent, depending on the client’s goals and objectives. A typical CBG client, Weiss says, has about 10 percent invested in hedge funds. “But if you ask our chief investment officer in Geneva, he wants to bring the percentage to around 30 percent for a typical client portfolio. He doesn’t see the global markets on an up-line, and he sees a lot of interim volatility, so he sees hedge funds and alternatives as a safer place to be.”

Allison reports that Beacon Pointe ran a constrained optimization model—with the market-neutral hedge fund investment constrained to 15 percent—and found that by adding the hedge fund element, the client’s portfolio risk is reduced while there is a potential increase in return. This seems to confirm that a constrained allocation to hedge funds improves the risk-and-return characteristics of a portfolio.

Options Abound
Since their inception, hedge funds have possessed a well-deserved reputation for exclusivity. According to Hedges, during the 1980s it was difficult for many investors to gain access to hedge funds. “It was an entirely cocktail-circuit-driven method of marketing—it was antimarketing marketing.” Recognizing an unmet need, Hedges and his family established LJH Global Investments in Naples, Fla., to provide hedge fund access to other wealthy investors. This sort of hedge-centric entrepreneurship, combined with a proliferation of new funds, has enabled the private investor to gain exposure to this once-exclusive asset class.

Yet experts caution that direct investment in hedge funds is only advisable for those of us with considerable investable assets. “Unless you have a minimum of at least $10 million, conservatively, to invest, then it doesn’t make sense to allocate to hedge funds directly,” says Raj Mehta, founding partner and managing director of advisory firm Persistent Edge Management in San Francisco. Following Mehta’s advice, with a 10 percent direct-investment hedge fund allocation worth $10 million, we should ideally have investable assets of roughly $100 million.

To get the benefits of hedge funds then, most advisors recommend that only the ultra-wealthy or family offices opt for direct investment, with funds of funds or an index investment being a more appropriate vehicle for others. “You need a critical mass of money to build a diversified portfolio of at least 15 to 20 managers, as there is a significant amount of strategy, style, region and manager risk,” Mehta says. “And you also need enough time, energy and resources to manage that.”

GRAPH 2 illustrates the historical volatility of the CSFB/Tremont index compared with that of the S&P 500. To date, the equity index has consistently recorded more volatility than its hedge fund counterpart. (Click image to enlarge)

Hedge Fund Performance
Analysis of the historical returns figures of the CSFB/Tremont Hedge Fund Index since its inception at the end of 1993 shows mixed performance. As Graph 1 indicates, the index did not start to outperform the S&P 500 equity index until the technology bubble of the late 1990s truly burst. Since then, it has consistently outperformed its equity counterpart. But looking at the returns figures tells only half the story. The volatility, or risk, that an investor has to take to make those returns is equally important. (See Graph 2 above.) And it is here that the hedge fund index shows its real value. The S&P 500 has been consistently riskier than the CSFB/Tremont index.

Hedge Funds of Funds
For those without the investable assets necessary for direct hedge fund investment, funds of funds offer many traditional hedge fund benefits with lower investor capital requirements. Using pooled assets, these funds invest in a number of hedge funds on behalf of investors. They offer diversification, and perform the same thorough due diligence that wealth advisors perform for direct investors. As such, funds of funds reduce both idiosyncratic hedge fund risk, and the traditional time burdens associated with fund maintenance. Likewise, hedge fund index investments, such as those linked to the CSFB/Tremont index, offer similar benefits.

There are, however, downsides to these investment vehicles. Hedge funds charge relatively high fees—typically a 1 or 2 percent annual management fee plus up to 20 percent of any upside generated. A fund of funds client pays these fees plus another similar set of fees to the fund of funds manager.

Emerging Investment Styles
Hedge fund managers employing established investment styles to take advantage of market volatility and inefficiencies are finding that in the competitive world of hedge funds, popular strategies have limited shelf lives. “We’ve had to go outside the United States to find additional strategies, because there really aren’t a lot of inefficiencies left in these markets, or in the markets that U.S.-based investors target,” says Harry Krensky, managing partner and founder of South Norwalk, Conn.-based Discovery Capital Management.

The problem, Krensky explains, is the proliferation of new hedge funds chasing a limited number of opportunities. “Whether it’s risk arbitrage, convertibles or fixed income, there has been so much capital going into these areas that opportunities are much lower than they were,” Krensky says.

According to Joelle Weiss, president of CBG Investment Advisors in New York, the dearth of opportunities is forcing managers to come up with new strategies in which hedge funds would not normally engage, such as lending directly to businesses. “I’m finding a lot of managers going into the private lending market space, which is not good, because it’s not liquid,” she says. “They’re moving away from the public market and lending to companies that have no other place to borrow, so it’s kind of like distressed debt.” The idea, Weiss says, is that the hedge fund does its own fundamental credit research and identifies a company that it thinks the market has misjudged as about to go bust, when in fact there is a good chance that it will turn around with a little backing. The hedge fund then gives the business a direct loan and charges a relatively high rate. Says Weiss, “It tells you that the public markets are not offering anything attractive at the moment.”

Additional Information
Hedge Fund Investment Styles