Building a First-Rate Hedge Fund Portfolio

Given all the difficulties of investing successfully in hedge funds, investors have resorted to various and sundry strategies designed to improve the odds. Let's take a look at the main strategies used by hedge fund investors.

Designing a separate hedge fund portfolio. A great many investors have built what they think of as separate hedge fund portfolios that are designed to improve their overall returns, but that aren't thought of as playing a particular role in the overall investment portfolio. The trouble with this approach is that, if we don't have an expectation for exactly how the hedge fund portfolio is supposed to behave, how can we know whether it is working for us or not? The notion that it doesn't really matter as long as the hedge fund portfolio is performing well is naive. No hedge fund portfolio, however well designed, will always perform well. Thus the question is always before us: When the hedge fund portfolio isn't performing well, is it still playing a worthwhile role in our overall portfolio? We need to know the answer to this question, but too many investors aren't even asking it.
Using long/short hedge funds as the high-alpha component of an asset class strategy. One of the best uses of hedge funds, especially directional funds, is as the high-alpha portion of an equity strategy. We could decide to index a core position in U.S. equities, then build a satellite position using long/short hedge funds. One difficulty ...

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