Getting Ready Is the Secret of Success
Portfolio Construction
Now that we have walked through an extensive process to research and select a hedge fund manager, the final test for the fund selected is how it fits into your current portfolio. All of the cumulative work, if done properly, will increase your probability of success. As we discussed in Chapter 1, the process began by outlining the goals and objectives in an investor’s Investment Policy Statement (IPS). The IPS gives the particular client’s investment criteria for risk and return, which leads to the manager selection. After that, you still need to perform three steps:
1. Top-down strategy analysis.
2. Bottom-up manager analysis.
3. Modeling and testing of the final portfolio.
After the due diligence process is complete, an investor needs to make a portfolio decision as to what effect or impact a particular hedge fund will have on the current exposures in his overall portfolio. The obvious temptation is to put the highest performance fund into the portfolio. You should resist that temptation until you can quantify the expected strategy returns and the correlations of the fund, not only to its peers (your other holdings), but also to general market benchmarks. You also need to be comfortable with the risk exposures of possible short positions and leverage in the fund. Now we look at how to quantify those exposures. The key to successful portfolio construction, whether you are picking stocks or picking managers, ...

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