Most investors can achieve similar performance in a properly diversified portfolio of stocks and bonds as they can in the average fund of he...

Most investors can achieve similar performance in a properly diversified portfolio of stocks and bonds as they can in the average fund of hedge funds, according to a historical analysis of hedge fund investment performance by Presidio Financial Partners, a US wealth management firm. Presidio’s research found that a diversified portfolio between April 2000 to March 2006 generated an average annualized return of 6.3 per cent, compared with 5.2 per cent for the HFRI Fund of Funds Composite Index. Over a longer period, from January 1990 to March 2006, the same pattern of investment returns was repeated, said Presidio. The diversified portfolio of investments generated an average annualized return of 10.6 per cent compared to 10.1 per cent for the HFRI Funds of Funds. January 1990 is the inception of the HFRI Index. “Our research (Demystifying Hedge Funds II) is not intended to dissuade individuals and institutions from hedge funds, which remain an important component of a total asset allocation strategy,” said Jeff Spears, head of Presidio Wealth Management, the firm’s investment consulting business for clients with more than $10 million in investable assets. “The point is that as hedge funds become more popular, investors need to proceed with caution. Finding the top performing funds is exceedingly difficult, but there are hedge funds that are absolutely worth the additional fees and risk.” The study found that only 12 to 15 of the more than 1,000 HFOFs – and no more than 250 of the more than 8,000 individual hedge funds – deliver performance in line with their higher fees. The analysis reached that conclusion after evaluating the seven factors: • Top down management: Most HFOFs base their strategy exposures on historical or backward-looking data or rely on arbitrary fixed-weightings. Successful managers have a forward-looking view about which strategies are likely to perform well in the future. • Access to top-tier talent: A good percentage of HFOFs have a few flagship hedge funds as anchor managers with whom they have good relationships. The quality of hedge fund managers beyond those few is often mediocre to poor. • Strong pipeline of prospective managers: HFOFs must constantly look to upgrade the quality of the investment programme. Unfortunately, most successful HFOFs cannot fire their larger managers because they don’t have the talent or capacity to replace them. • Deep knowledge of hedge fund industry/strategies: Most HFOF personnel lack the sophistication to comprehend complex hedge fund strategies and instead gravitate toward easy-to-understand strategies, such as long/short equities, merger arbitrage, and convertible bond arbitrage. However, the more accessible the strategy, the more likely that abnormal profits have already been extracted. • Sophisticated risk management systems: Sophisticated HFOFs place a strong emphasis on risk management, both qualitatively and quantitatively. Most HFOFs have little or no risk management systems. • Ongoing due diligence and monitoring: Most HFOFs devote almost all of their time to due diligence. However, too many HFOFs are wedded to hedge funds they have used for a long time – often well past their prime. HFOFs need to be open to replacing managers when warranted, while avoiding unnecessary churn.