are critical aspects of portfolio performance
as evidenced by the return dispersion
among funds with various strategies.
Investors can’t overlook basic “blocking
and tackling” due diligence because of a
perceived need to invest with a hot manager.
ai5000: Do the benefits of funds of funds
still loom as large in the post-2008 world?
Krieg: An important decision for many
hedge fund investors is whether to invest
directly or via a fund of hedge funds
approach. One of the historical arguments
against a fund-of-funds structure was the
added layer of fees or costs. However,
these costs reflect a number of benefits
and services, including full-time dedicated
professional staff who build and maintain
portfolios; continuous monitoring,
negotiating and leveraging on fees, monthly
reporting and, finally, consultative services
and customized solutions.
Think about the costs associated with
these additional benefits. As an investor, if
you have the resources to manage a hedge
fund program and the assets to develop
a well-diversified portfolio, then a direct
investment approach is a viable option. If
you don’t have the resources to perform
the previously mentioned functions,
then a fund-of-funds investment may be
considered but you still need to go through
the thorough due diligence.
Several recent hedge fund studies identify
funds of hedge funds as expected to
capture significant flows over the next three
to five years—especially in the U.S. Given
limited capacity to conduct the necessary
due diligence and ongoing review, funds of
hedge funds may be really the only viable
approach for many investors.
ai5000: Where are we on the question of
hedge funds as a stand-alone asset class?
Krieg: The mean/variance optimization
process and resulting asset allocation
used by many investors lends itself to an
asset class framework—hence, a naive
allocation to alternatives, for example,
10% to 15%, is an approach taken by
many investors. Often, fiduciaries feel the
importance of accounting for hedge funds
as an asset class in their policy portfolios
and to monitor this exposure given certain
“We believe investors will continue
to use hedge funds as risk
stabilizers or return enhancers
in their portfolios.” — Krieg
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“There is no industry standard
for reporting leverage.” — Zanolla
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unique characteristics of hedge funds.
Are hedge funds an asset class or a
strategy? More investors are recognizing
that hedge funds themselves are not an
asset class but a collection of alternative
strategies with exposures to various asset
classes and unique investment themes.
We believe investors will begin using hedge
funds and other alternatives in different
ways in their overall portfolio construction.
ai5000: Where will the flows that come
into hedge funds be originating? Are they
coming from some pre-set “alternatives”
exposure, or from long-only assets?
Krieg: While both channels likely will
continue to originate flows into hedge
funds, we believe the long-only space could
be a greater source over the next few
years—especially from investors that have
the longest hedge fund experience.
Investors are recognizing that hedge
funds are not an asset class but rather an
investment strategy. As a result, a hedge
fund or the fund-of-funds structure can be
constructed to act as a substitute for part
of their fixed-income or equity exposure.
For example, when deciding how to
implement the large-cap exposure (say
S&P 500) in an asset allocation, an
investor has an array of choices, including
index funds, enhanced index, quantitative
or fundamental active, and even synthetic
structures, like futures or total return
swaps. Hedge funds, like hedged equity,
are also an option. Hedged equity may
provide exposure and upside capture
to large-cap equities while significantly
reducing downside volatility. Comparing
the S&P 500 versus the equity hedge
universe over the past 10 to 15 years (as
measured by Hedge Fund Research) points
to hedged equity having higher annualized
returns, good protection of capital when
the equity markets suffer, and 60% of the
volatility of the S&P 500.
ai5000: How has investor tolerance for
volatility and illiquidity changed?
Krieg: Investors understand that earning a
return above the risk-free rate is a function
of volatility and less than perfect liquidity.
No doubt their tolerance for volatility and
illiquidity was tested over the past six to
nine months. Going forward, investors