New Bottoms Up Approach to Hedge Fund Investing

Investcorp, an investor in hedge funds with $5 billion in assets under management, has created a proprietary, bottoms-up method for choosing the best managers.  Deepak Gurnani, the Chief Investment Officer, started the Alpha Project in 2003.  The research approach consists of reviewing the performance of trades for each hedge fund strategy.  For example, for merger arbitrage, Investcorp examined every merger since the 1990's and analyzed the performance of that classic trade.  These individual trades are compiled into fund returns.  The results are used for tactical asset allocation among different funds, manager selection and investing Investcorp's assets.  Its portfolio has a better risk adjusted return (as measured by the Sharpe Ratio) even after subtracting fund costs (i.e. prime brokerage and stock loan).  This is in stark contrast with traditional research that looks at the performance of equity markets, volatility, credit spreads and currencies to explain hedge fund returns. There are four issues with this approach:

• Fund strategy contributes to returns
• Investors only receive 25%-50% of alpha returns because of the 2 and 20 incentive fee structure
• Risk and transparency issues such as style drift, side pockets and insider trading
• Liquidity