Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Summary and Outlook

Evaluating individual funds usually starts with an analysis of a fund's historical data and its current exposure or sensitivity to market risk factors.

Investors need to evaluate both the performance and risks of any fund and then form an opinion about return expectations and the anticipated correlation of fund results with their existing portfolio.

Picking a manager based on past performance alone is not sufficient. In fact, academic research indicates that performance is not necessarily persistent over time, particularly longer time frames. A great manager today may not be the best manager tomorrow. Surely, there are some managers and funds that can remain on top, but this appears to be the exception rather than the rule. Allocating capital based on recent performance may lead to herding and less than stellar results, as investors all pile into the latest winners, who then fail to meet expectations.

Once a complete review of the empirical characteristics of a fund has taken place and a list of choices created from the data, investors can then start the more labor-intensive and high-quality process of evaluating the manager, the fund's service provider, references, pedigree, and a host of variables designed to assess the particular opportunity.