The Stewardship of Wealth: Successful Private Wealth Management for Investors and Their Advisors, + Website

Challenges for Hedge Fund Investors

A few years ago advisory firms faced an uphill battle trying to convince investors to add hedge fund exposure to their portfolios. Today the problem is almost the opposite—when an advisor first encounters new clients they are as likely to have too much hedge fund exposure (or the wrong kind of exposure) as to have not enough. Whether investors are drawn to hedge funds for their return potential, whether they are fleeing debacles in other capital markets or whether they are simply seeking prudent diversification, the problems today are too much haste, too little caution, and diligence that is too superficial.

Probably the main challenge for investors in hedge funds going forward is the one just mentioned: the popularity of hedge fund investing. The more money that pours into a sector, the more difficult it will be for managers to add value. Vendors in the hedge fund business will argue that, though some strategies are naturally capacity constrained—merger arbitrage, for example—others are not.⁷ Long/short equity managers and fixed-income arbitrage managers play in markets that are measured in the trillions of dollars. Hence, so the argument goes, even a manager with several billion dollars under management will represent only a tiny drop in the vast ocean of opportunities.

But this is the wrong measure. In U.S. large caps, the question isn't whether or not any individual manager has a lot or a little money to work with. The question is how much ...