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Picking Top-Quality Hedge Funds Research Team | Posted On Wednesday, April 15,2009, 05:58 PM

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Picking Top-Quality Hedge Funds



With so many hedge funds in the investment universe, it is significant that investors know what they are looking for in order to make more efficient the due diligence process and make timely and appropriate decisions. Search strategy can be used as performance metrics to determine hedge fund regularity over time and to appraise the guidelines themselves to determine whether the guidelines remain convincing across different economic environments. Lastly, guidelines can help third parties to better support an investor in his or her search process.

Types of Guidelines

When looking for a high-quality hedge fund, it is significant for an investor to define the metrics that are significant to he or she and the outcome required for each. These strategies can be based on absolute values, such as returns that exceed 20% per year over the preceding five years, or they can be comparative, such as the top five highest-performing funds in a particular category.

The first rule an investor should set when selecting a fund is annualized rate of return. Let's say that we want to find funds with a five-year annualized return that go beyond the return on the Lehman Brothers World Government Bond Index (LBWGBI) by 1%. This filter would get rid of all funds that underperform the index over long time periods, and it could be attuned based on the performance of the index over time.

Absolute performance guidelines

This principle will also disclose funds with much elevated expected returns, such as global macro funds, long-biased long-short funds, and several others. But if these aren't the kinds of funds the investor is looking for, then he or she must also set up a principle for standard deviation. Once more, we will use the LBWGBI to calculate the standard deviation for the index over the preceding five years. Let's suppose we add 1% to this results and establishes that value as the principle for standard deviation. Funds with a standard deviation larger than the instruction can also be eliminated from further consideration.

Regrettably, high returns do not necessarily help to recognize an attractive fund. In a few cases, a hedge fund may have employed an approach that was in favor, which drove performance to be superior to normal for its category. Consequently, once certain funds have been identified as high-return performers, it is significant to identify the fund's strategy and in contrast to its returns to other funds in the same category. To do this, an investor can establish guiding principle by first generating a peer analysis of comparable funds. For instance, one may establish the 50th percentile as the principle for filtering funds.

Now an investor has two guiding principle that all funds require to meet for further consideration. Nevertheless, applying these two guiding principle still leaves too many funds to evaluate in a logical amount of time. Further guiding principle require to be established, but the further guidelines will not necessarily be relevant across the remaining universe of funds.

For instance, the guiding principle for a merger arbitrage fund will be different from those for a long-short market-neutral fund.

Relative performance guidelines

To smooth the progress of the investor's search for high-quality funds that not only meet the initial return and risk strategy but also meet strategy-specific guiding principle, the next step is to ascertain a set of relative guidelines. Relative performance metrics ought to always be based on specific categories or strategies. For instance, it would not be fair to evaluate a leveraged global macro fund with a market-neutral, long-short equity fund.

To establish strategy for a specific strategy, an investor can make use of an analytical software package (such as PerTrac, Morningstar or Zephyr) to first identify a universe of funds using comparable strategies. Followed by, a peer analysis will reveal many statistics, broken down into quartiles or deciles, for that universe.

The threshold for each principle may be the outcome for each metric that meets or exceeds the 50th percentile. An investor can relax the strategy by using the 60th percentile or stiffen the guideline by using the 40th percentile. Using the 50th percentile across all the metrics usually filters out all except a few hedge funds for further consideration. Additionally, establishing the strategy this way allows for elasticity to adjust the strategy as the economic environment may impact the absolute returns for some strategies.

Putting it all together

Here is a list of primary metrics to use for setting strategy :

  • Five-year annualized returns
  • Standard deviation
  • Rolling standard deviation
  • Months to recovery/maximum drawdown
  • Downside deviation

Setting up guiding principle helps streamline the hedge fund search method by eliminating funds that should not be considered and allowing an investor to focus his or her time performing due attentiveness only on funds that are worth evaluating. These strategies can also assist third-party marketers and/or institutional platforms in targeting prospective investors for particular funds.

These strategies will help get rid of many of the funds in the universe and identify a workable number of funds for further analysis. An investor may also want to think about other guidelines that can either further decrease the number of funds to analyze or to recognize funds that meet additional criteria that may be important to the investor. Some of the examples of additional strategy include :

Fund size/firm size - The instruction for size may be a minimum or maximum depending on the investor's inclination. For instance, institutional investors often invest such large amounts that a fund/firm must have a minimum size to provide accommodation for a large investment. For other investors, a fund that is too big may face future challenges using the same tactic to match precedent success. Such may be the instance for hedge funds that invest in the small-cap equity space

Track record - If an investor wants a fund to have a minimum track record of 24 months or 36 months this principle will get rid of any new funds. Nevertheless, sometimes a fund manager will leave to start his or her own fund and even though the fund is new, the manager's performance can be tracked for a much longer time period.

Minimum investment - This criterion is very significant for smaller investors as many funds have minimums that can make it complex to diversify properly. The fund's minimum investment can also give a suggestion of the kinds of investors in the fund. Larger minimums may specify a higher proportion of institutional investors, while low minimums may specify of a larger number of individual investors.

Redemption terms - These terms have implications for liquidity and become very significant when an overall portfolio is extremely illiquid. Longer lock-up periods are harder to incorporate into a portfolio and redemption periods longer than a month can present various challenges during the portfolio-management method. A principle may be implemented to get rid of funds that have lockups when a portfolio is already illiquid, while this principle may be relaxed when a portfolio has sufficient liquidity.

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