Handbook of Hedge Funds

25

Hedge Fund Selection: A Route Through the Maze

Markets can remain irrational longer than you can remain solvent.

John Maynard Keynes

Once the investor has decided the percentage of his portfolio to be allocated to hedge funds, the fund selection process can start (Figure 25.1). Simply stated, the role of the hedge fund selection process is to screen the industry for exceptional talents. Gaining access to one of the very few quality managers was for long the most difficult element of investing in hedge funds. Historically, hedge funds were only available through the “whisper network” of large institutional and very wealthy individual investors. There was no question of selection. The question was rather one of being invited to invest in a fund!

The strong economy and raging bull market of the 1990s have expanded the pool of vehicles, and the problem is now exactly the opposite: choosing a particular hedge fund in a universe of about 6000 funds can be one of the most daunting challenges an investor has to face, even though it need not be. The lack of publicly available information and the limited transparency of hedge funds do not facilitate the selection process. In addition, the consequences of being wrong are weighty. Even in a small peer group, the dispersion of risk and returns among hedge funds can be quite large, particularly on the downside, since no common benchmark or tracking error federates the asset allocation.

That being said, it is possible to avoid a large number ...