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The Alter-NATIVE series How to select the right hedge funds for your clients?

How to select the right hedge funds for your clients?

Advisors can evaluate the performance of hedge funds through investment style and operational efficiency of an organization.
Nalin Moniz Aug 28, 2017

So how does one get around to evaluating funds and selecting the right one?

The evaluation of hedge funds has two critical components: an investment evaluation and an organizational and operational evaluation.

On the investment side, a manager has to be evaluated on five critical skills. First, they have to outperform on the long side or on their bullish bets. Second, they have to outperform on the short side or on their bearish bets. Third, they have to be adept at non-market linked opportunities such as high yield debt, arbitrage or special situations. Fourth, they need to have a defined process for capital allocation. And fifth and perhaps most importantly, they need to have robust risk management policies and frameworks.

Unlike mutual fund managers who are largely homogenous in their approach, hedge fund styles can vary dramatically. Some managers have short term trading led approaches while others have long term investment led approaches; in some cases longs and shorts are linked through the use of pair-trading and in others they are run separately; some funds are closer to market neutral and run very low beta while others have portfolios with higher beta; some funds actively trade options while others eschew them entirely. The use of derivatives also means that cash utilization and economic exposures are not the same. This often confuses investors who are used to long-only portfolios where the two are the same. Hence, it is worth asking each manager how cash utilization differs from economic exposure.

The Indian market is still evolving and managers have a shorter track record compared to their mutual fund peers, so it is important to look at each potential manager independently and ask them both qualitative and quantitative questions on the five skill sets laid out above. We anticipate that over a period of time either global evaluators & databases like Mercer or Eurekahedge or local evaluators like Value Research and CRISIL will do this for you but for now this key due diligence is left to a client’s advisor. Thankfully, there are only a handful of managers at the moment and this is not as daunting a task as it seems. We caution you against chasing returns on this category of funds, because past performance may not be indicative of future performance especially when portfolios are dynamically managed.

Hedge fund sponsors range from established financial service players to boutique firms. Given the range of firm sizes and the idiosyncratic style of each of the funds it is important to evaluate the ability of an organization to deliver on the mandate of the fund beyond a single star fund manager. This is especially important because the minimum investment amount of Rs.1 crore represents a material financial commitment for an investor. An independent risk management function, a documented process driven approach, fund manager & investment team experience and the commitment of both the firm and the fund manager to invest in the fund are important elements of this evaluation.

We also encourage clients and advisors to focus on operational best practices including reporting of post-fee, post-tax returns; methodology for calculation of tax and performance fees; disclosure of portfolios and risk metrics; and transparent and relevant monthly attribution and commentary. We hope that SEBI prescribes a uniform reporting standard for all AIFs as it will build investor trust and confidence in the industry. But in the meantime, managers that adopt operational best practices and are client-first in their approach are likely to see their businesses grow faster.

Globally, hedge funds are a $3.2 trillion industry and occupy approximately 5% of investors’ portfolios. We anticipate that the local industry will grow approximately 5X from 8,483 crore to 40,000 crore in the next 5 years with a core set of 10-12 credible and large managers who will collectively manage 80% of these assets. The focus is likely to remain equity oriented strategies like equity long-short, but may also expand to include newer asset classes like commodities. A secular decline in interest rates will drive investors to hunt for yield and is a catalyst for funds that are fixed income alternatives. While, diminishing outperformance in the large cap mutual fund space is likely to drive a separation of alpha and beta with investors choosing to invest in low cost ETFs and equity oriented hedge funds. In the meantime, we encourage clients and advisors to give the industry a try – the present set of managers have done very well for investors and have the right ingredients to keep delighting investors with strong risk-adjusted returns.

Nalin Moniz is the Chief Investment Officer – Alternative Equity, Edelweiss Global Asset Management

Past performance is not an indication of future performance. Investments in the securities market are subject to market risk.

Please read the Private Placement Memorandum carefully before investing.

 

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