Creating a Hedge Fund Portfolio

Earlier, I had written some articles regarding how investment advisors and consultants pick the best mutual fund managers for their portfolio.  Let us return to hedge funds and discuss how fund of hedge funds do the same.  Again, I will rely on presentations from NYSSA's Fourth and Fifth Annual Manager Search and Selection Conferences.  I have combined details from three experts over the two conferences.  They are:

• Ben Appen, CFA - founding partner at Magnitude Capital (Fourth)
• Jeff Moses, CFA - Lyrical Partners (Fifth)
• Robert Teeter - Ten-Sixty Asset Management (Fifth)

Magnitude Capital uses experienced hedge fund professionals to source investments.  The team includes senior employees from UBS, Deutsche Bank and D.E. Shaw who have extensive contact lists.  They use a six step process to make investment decisions:

1. Risk Management:  In addition to accounting for the common risks (i.e. credit, liquidity, etc.), Ben considers crisis risk management.  The credit crisis of 2008 saw a rapid decrease of available borrowing, illiquidity in certain products and cross asset selling.  Rob also asks if liquidity is needed for the whole or just part of the portfolio.
2. Strategy Analysis:  Ben and Rob invest in different strategies based on market conditions.  Jeff focuses on buying long/short managers at a discount to the Net Asset Value of the fund.
3. Sourcing:  Networking, hedge fund service providers, databases and conferences are used to find managers.  Rob noted that there was greater institutional demand for the largest hedge funds.
4. Evaluation and Due Diligence:  Both quantitative and qualitative methods are used.  In the former case, past returns, correlation of these returns with other investments and how they affect the current portfolio are analyzed.  The latter method includes meeting with managers, reference and background checks, reviewing the fund's operations, auditing financial statements and general administrative review.
5. Portfolio Construction:  Ben's firm has a proprietary "optimizer" to help make investment decisions.  It ranks the incremental value of each manager.  This rank plus the investment team's judgment creates the portfolio.
6. Monitoring:  Ben tracks market conditions, portfolios (using monthly risk reports) and managers (weekly estimates, monthly risk reports, quarterly meetings and quantitative analysis).  Jeff wants to have broad conversational openness with managers in addition to receiving detailed portfolio holdings.  Rob said that transparency was increasing but wondered if people were taking advantage of the situation.  He noted that knowing the holdings in a portfolio does not make people aware of all the risks.

If you would like to read more advanced articles that are thoughtful and insightful, please go to Hedge Fund Portfolio blog.