Selecting a Hedge Fund

Funds are king these days and there are thousands of them to choose from, with many being quite similar in many respects. Selecting a fund can be quite a daunting task for individual investors, as they are placed in situations that really require a lot of analysis and expertise and they tend to be in very short supply of either.

Most investors do not really engage very much in selecting funds, and tend to instead go with recommendations of advisors or brokers. Advisors and brokers will of course tend to recommend funds from among those which they sell, although this isn’t necessarily that bad a thing since this at least narrows the field and makes selecting funds more practical.

The criteria for selecting a hedge fund isn’t that much different from selecting a mutual fund, although if we’re focused on index mutual funds or ETFs then this is made a whole lot easier for us since funds that track a certain index will be similar other than differences in management fees, which are usually pretty slight.

When we look to select among actively managed funds, rather than just ones that track an index, there is much more to look at and decide, as we’re comparing the quality of the fund management among different funds essentially. This quality can and does differ quite a bit across different funds.

Hedge funds are by their very nature actively managed funds, and hedge funds also tend to be more complex, and in some cases, much more so, so this takes the decision making even further beyond the normal abilities of typical investors.

While being able to buy shares in a hedge fund does require that investors be deemed to be accredited, this usually only means that they have enough financial means, a certain amount of wealth, and this usually has nothing to do with any accreditation based upon investing skill or experience.

Therefore, individuals can become quite challenged in trying to make a good decision about which hedge fund to go with, and will rely more on things like reputation, size, and past returns to base these decisions on. While these criteria do matter, the more informed we are here, the better decisions we will make.

Why Return Isn’t Always a Good Benchmark

Past investment performance isn’t all that bad of a criterion when comparing actively managed mutual funds, as it does at least give us an idea of how well a fund may be at selecting and managing its components.

Selecting a Hedge FundWhile some of these results may be influenced by luck, just happening to be in the right assets, and if we buy based upon that we may end up looking back and wishing we had gone with another fund or funds if our chosen fund’s luck doesn’t continue, there’s always more to this than just luck and there will always be some skill involved as well.

A fund that does well relative to the market for a statistically significant period of time does mean something, or ones that perform consistently in the top quartile of funds, as luck alone cannot explain this.

There is quite a bit of skill that goes into asset selection in a fund and while we want to make sure that we’re not just looking at time frames that are too short to be that meaningful, last year’s return for instance or a 3 year average return, we should be giving time frames such as 5 or 10 years some real weight.

We also want to pay attention to whether or not a fund has had the same fund manager over the time frame we’re looking at, as the old manager may have left during this period and a new one hired and the new person may not be as adept, and often is not, which will of course influence our outlook and the validity of this data.

Hedge Fund Analysis Isn’t Just About Comparing Returns Though

Looking at past performance really only speaks to performance though, and it does not speak to risk management, at least directly. Mutual funds don’t really do much risk management and are for the most part all exposed to the same market risks, so there isn’t even much of a need to look at this when evaluating mutual funds.

The primary goal in fact with hedge funds is to manage risk first and allow returns to flow from this increased risk management. There is of course an attempt to manage performance as well but only in the context of chosen risk management strategies.

Even long-short hedge funds, which seek to profit from both bull and bear markets by using both long and short strategies with their investments, are doing this not only to profit in any environment but to reduce the overall risk of their fund.

Mutual funds of course leave their positions unprotected against movements against them. If they are invested in a basket of stocks and the stock market is declining, seeking to make changes in the basket of stocks they hold will only do so much to manage risk and won’t do very much at all if the market itself is declining significantly.

Long-short hedge funds aren’t exposed to the full risk of this and instead change both what they hold and what side they are on them, long or short in other words.

If we are in a bull market and we compare returns with an index fund with a long-short hedge fund, we will usually see the index fund deliver higher returns over this time, and we might think that therefore the index fund is superior.

When we calculate risk exposure though, we will see that the index fund or other long based fund is quite a bit riskier than a hedge fund, and the idea here is that these risks will come to pass and the overall expectation for the hedge fund in the longer term may be greater, in addition to exposing us to less risk, being caught in and having to sell during or after a bear market decline.

It is therefore important to measure and compare risk ratios when comparing hedge funds, and this is something we can quantify, for instance by measuring a fund’s Sharpe ratio, its relationship between risk and reward essentially. Sharpe ratios measure risk adjusted returns, where if a return has a higher risk component it will be reduced by this risk, and therefore this is a good way to determine overall risk return analysis with any investment, including with hedge funds.

We need not be proficient in statistics to use this sort of data, all we really need is a basic understanding of what is being measured and why it is important, and this is quite important indeed when comparing hedge funds. What we’re after is higher risk-adjusted returns, and one can just compare the numbers and be guided by them.

While it is true that just being guided by an investment’s Sharpe ratio does not necessarily tell the whole story and may be an oversimplification, we also need to keep in mind that individual investors are not really going to want to get into any sort of complex statistical analysis, and need something that is both simple to understand and practical to use, and this ratio does serve them well on both counts,

Other Considerations in Evaluating Hedge Funds

Hedge funds are run on the basis of talent, and although this is something that investors will not have an easy time evaluating, we still need to have a look at who is running the fund, how long they have been doing it, what their results have been, how well the company is run, and so on.

There are a lot of hedge funds out there of various qualities, and some might be fairly new and have a lot of relative unknowns, and hedge funds are actually quite private with a lot of things surrounding them, not wanting to give away proprietary secrets for instance.

With regulated funds, a lot of transparency is required, to excess actually, and investors must be informed of any and all details surrounding the fund, which anyone who has read a prospectus will attest to.

Hedge funds aren’t really regulated in the same way, and not even close, and a lot of the workings of the fund is actually behind a curtain, hidden from investors and competitors alike. A fund may disclose what its overall strategy may be but not tell you much about how they are putting their plans into action, even if you own shares of it.

With all this lack of transparency, this places a high premium on reputation, and many funds really haven’t built up much of a reputation yet due to their shorter history. Investors are wise to take this well into account, and while this does not mean that we should always avoid newer funds, we do need to place a special weight on a fund’s reputation when seeking to decide among them, mostly because we may not have a lot else to go with.

How long a fund has been successfully operating is another big factor, going hand in hand with reputation, as a fund builds their reputation over time. Here though we’re looking at past performance more than anything, seeing how they did in different environments, for example how they did during the crash of 2007-2009, which was a time that particularly exposed investment risk.

There are also things like the fees one hedge fund may charge over another, and cheaper is not necessarily better here. A top fund may not provide any discounts to their clients because they may not need to, where a less successful fund may be required to do so in order to attract enough business.

It is the returns net of fees that matter here and if a fund charges more but delivers more net of their fees, and does so over a longer period of time, they certainly may be a better choice over a fund that charges less and has lower net returns.

Once again though, with hedge funds it’s not about the absolute return, its risk adjusted returns that we need to pay attention to, which can make calculating net returns more difficult, but we can still get a good idea by just looking at the numbers and making sure higher costs are justified.

Things like minimum investments, how easy it is to cash in your shares, and other distinguishing factors of funds, which differ across funds, need to be accounted for as well. If you desire more liquidity, you may not want to go with a fund that requires you to lock your money in for a couple of years for instance, and go with one that requires less of a commitment.

Selecting among funds is never an easy task, but it need not be too overwhelming either. This is the case even with hedge funds. You have to decide based upon something, and the key is to look to simplify the decision as much as possible while realizing that this is not a simple decision.

We can look at a few key things like how the fund is doing, their risk adjusted historical returns, their management, their popularity, and so on, and this can at least provide us with a workable means of guiding us and looking to at least get into one of the better hedge funds out there.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.