Over the last decade or so, Hedge funds have garnered public attention largely due to news headlines reporting spectacular wins and losses for some notable funds. They also represent a significant phenomenon in the asset management space fueled by the dramatic growth in the number of hedge funds.
Institutional investors such as pension plans, and endowments that have long stayed away from such investments are now attracted by the prospects of higher returns associated with absolute return strategies of hedge funds. Coupled with this growth, however, is an increasing awareness that hedge funds are introducing new dimensions of risk to the global capital markets. This is because hedge funds often resort to opportunistic non-traditional investment approaches to deliver growth. Many of these approaches are not well-understood in terms of the risks associated with them.
Unlike traditional silo-based approaches to risk, hedge fund investments often involve a combination of multiple risk dimensions such as:
- Market Risk
- Credit Risk
- Liquidity Risk
- Operational Risk
- Geopolitical Risk, and so on…
In reality, these “silos” of risk are interdependent in absolute return strategies and, therefore, they cannot be measured, nor understood, in isolation.[perfectpullquote align=”full” cite=”” link=”” color=”#EEEEEE” class=”” size=””]By approaching asset management firms as holistic businesses, rather than silos of securities and risk, investors and managers alike can work from a transparent, efficient, and quantitative framework to understand the risk of investment portfolios, business infrastructures, and counterparties as a whole.[/perfectpullquote]
To better appreciate the workings of a hedge fund, it is important to understand the differences between traditional notions of asset allocation versus those that are adapted by new age funds, esp. absolute return strategies.
|Tenet||Traditional Asset Allocation||Hedge Fund Asset Allocation|
|Allocation Vs Manager Selection||Asset allocation decisions more important than manager selection||Manager selection is extremely important|
|Fund Manager Compensation||based on Comparative relative performance w.r.t benchmarks||based on Absolute returns, not against relative benchmarks|
|Asset Class||Asset class specialization||Not constrained by asset class|
|Investment Style||Adherence to style discipline||Fund managers employ an array of investment strategies; not restricted to one particular style|
In short, the asset allocation paradigm requires adherence and covenants, while hedge fund strategies are typically opportunistic and organic.[perfectpullquote align=”right” color=”#16989D” ] the asset allocation paradigm requires adherence and covenants, while hedge fund strategies are typically opportunistic and organic.[/perfectpullquote]
The differences between traditional asset allocation paradigms and the opportunistic, and often “blackbox” nature of hedge fund investments often leave investors wary. So how does a hedge fund attract investments from suspecting investors, and how do investors access good prestigious funds that deliver high growth? This is the topic of Part-2 of our Hedge Fund Analytics story