Fund of Funds Investing: A Roadmap to Portfolio Diversification

Chapter 5. Understanding Alternative Investing Is Both Math and Science

To evaluate the performance results of individual hedge fund managers and the consequent aggregation of results of a portfolio of hedge funds, it is necessary to look at and understand the major influences on or drivers of hedge fund returns. Investors learned in the wake of the technology bubble's burst during 2000–2001 that the returns of many hedge fund managers, whose performance results in previous years had been skewed by participation in the high volume of initial public offerings, were mediocre at best. These investors believed prior to the market collapse that they had invested in a new breed of outstanding money managers.

Unfortunately, as technology stock prices fell, so did the value of many of their investments. As Warren Buffet once said, "you only find out who is swimming naked when the tides goes out." Investors learned who did and did not have the right stuff. The reason investors use or invest with a fund of funds is because they believe that the manager knows how to evaluate and decide who is and who is not swimming naked.

HEDGE FUND RETURNS

Hedge fund returns are driven by many factors, including

• Performance of the stock market

• Shape of the yield curve

• Credit spreads

• Direction of interest rates

• Volatility

Stock Prices

Global stock prices clearly drive performance. As many say, "A rising tide lifts all boats." In a bull market, all managers look brilliant. But what happens when the market heads south? ...