Managing Hedge Fund Risk and Financing: Adapting to a New Era

Determining the Asset Allocation to Hedge Funds

Investing in hedge funds involves non-traditional risk taking due to the complex, sometime illiquid or opaque nature of hedge fund investment strategies. Furthermore hedge funds receive comparatively little regulatory oversight. Investing in hedge funds is suitable only for sophisticated investors who are able to identify, analyze and bear the associated risks, and follow appropriate practices to evaluate, select, monitor, and exit these investments. If a sophisticated investor is comfortable taking such risks and has the skills or can outsource the work required to dynamically manage these investments, then the question becomes how much an investor should invest in hedge funds. An institution or high-net-worth individual may benefit from an intermediary partner (for example, a fund of hedge funds) that possesses the necessary qualifications and skills to filter through the many thousands of hedge funds and understands how the different hedge fund strategies can be optimally combined to generate consistent absolute returns.

Hedge funds emerged as an important alternative asset class during the last decade. Their non-normal risk-return characteristics and attractive absolute returns apparently helped institutional investors such as US university endowments to achieve a significant outperformance over traditional asset allocations for many years leading up to the financial crisis.¹ The substantial outperformance prior to the crisis ...