Empirical evidence indicates that investing in hedge funds, when done well, can provide higher portfolio returns, lower portfolio investment correlations, and partial protection against losses in down markets. But hedge fund investing comes with challenges that the typical long-only investor may not have faced previously.
Determining how much of a traditional portfolio to allocate to hedge funds requires a sophisticated assessment of the risk tolerance and targeted return expectations of the investor or as defined in the investment mandate. Creating an allocation that meets those requirements is complicated by the paucity of transparent data and the non-normal return distributions of hedge funds. Investors need to arm themselves with more sophisticated analytical techniques such as factor analysis, risk adjusted performance statistics that are appropriate for non-normal return distributions, and in-depth knowledge of hedge fund strategies to enable value-added due diligence. All this quantitative and qualitative analysis must then be brought together to screen and rank hedge funds. The screening and portfolio construction process must include advanced stress and scenario analysis for uncovering downside and ways to mitigate tail risk.
After the commitment has been made to a defined hedge fund allocation, those investments must be monitored to see if expectations are being, and are likely to continue to be, met. Tracking of factor exposures, correlations, and periodic ...