In the last article I posted, I took a closer look at hedge funds to address some common misconceptions about the asset class.
Contrary to popular belief, hedge funds are not overly-risky investments – over time they have proven to be resilient and delivered consistent returns, given the level of risk they take.
As an asset class, hedge funds can be utilised in most portfolios, especially since they help to provide diversification benefits. That is why at the Bank of Singapore, we advocate our clients to strategically allocate 10 per cent of their portfolio in hedge funds.
That said, even though it is a useful asset to hold, it is not that easy an asset class to invest in. Unlike vanilla stocks and shares, or even mutual funds, there is more to investing into hedge funds than their past performance.
Hence, I thought it would be useful to answer some questions on how to invest in hedge funds.
1. How should one go about investing in hedge funds?
First, investors should be aware that hedge funds are not off-the-shelf investments. There are some funds which are open to retail investors but most hedge funds are designed for and targeted to attract institutional investors.
Private wealth clients can gain access to hedge funds through their private banks, which may select hedge funds they think are suitable for them. Depending on the partnerships, each private bank may offer a different slate of hedge funds and varying levels of access for their clients
2. How should one pick a hedge fund to invest in?
Hedge fund managers can employ a wide range of strategies, including equity hedged, macro-themed, relative value and event driven strategies among others. Each of these strategies have a certain objective and risk profile. Your banker should be able to recommend you on which strategy is best suited for your risk profile.
Apart from fund characteristics, there are other less obvious factors that are equally important to fund selection. Top among them is conducting proper due diligence.
For one thing, not all funds are created equal and some may contain hidden risks that the average investor may not be aware of. While today it is easy for any investor to instantly access a wealth of information on traditional “long only” mutual funds, the same is not true of hedge funds. Many hedge funds provide little to no disclosure and use relatively complex trading strategies.
But knowing what you buy is an essential principle of investing. In the case of hedge funds, knowing what you buy requires conducting robust due diligence, which is lengthy, difficult and very costly.
One cannot just look at past performance. It is essential to have access to detailed information about the fund and to have the ability to analyse it. This is the only way to determine whether past performance has a good chance of being repeated in the future.
3. What are some key elements of conducting proper due diligence?
For qualitative assessments, a typical approach would be to analyse the “Four P’s”:
4. What is Operational Due Diligence and why is it important?
Investors also need to pay attention to operational due diligence before investing into a hedge fund.
Operational due diligence looks at the key “non-investment” related aspects of the hedge fund in question. This includes reviewing the fund’s operational procedures, organisational and legal structures, valuation methodologies of underlying securities, compliance policies and relationships with essential third-party service providers (for example, law firms, auditors and administrators).
Proper operational due diligence will also review a manager’s staffing, analyse key fund terms and review how sound its IT infrastructure and disaster recovery protocols are (these are all important things to know prior to any potential investment).
The importance of taking this step cannot be under-estimated. Due diligence can help identify funds that are likely to run into trouble or fail.
Superior operational due diligence contributes up to 2.6 per cent to the annual return of a diversified hedge fund strategy, a study by NYU Stern Professor Finance Stephen Brown showed.
If one thing is clear, it is this: due diligence on hedge funds cannot be done without the help of professionals.
Deep knowledge and access to information is crucial when making the decision to select hedge fund managers. As a result, Bank of Singapore partners with leading global consultants to supplement its own analysis capabilities and recommend clients on the best hedge fund portfolio suited to their investment profile.
The clients of these consultants include the world’s leading and largest institutional investors from sovereign wealth funds, public pension funds, university endowments, foundations and others.
As Professor Brown notes in his study: “Diversified hedge fund strategies, whether self-managed or through a fund of hedge funds, do have favourable returns per unit risk that they undertake and thus have a place in a well-diversified asset portfolio.”
In summary, the real question most investors should be asking themselves isn’t “why hedge funds” but rather “what is the best way to invest into hedge funds?”
Make sure you have a diversified portfolio of managers who have undergone robust due diligence conducted by professionals and do not hesitate to ask your banker to disclose the due diligence process prior to investing.Disclaimer applicable to recommendation
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