Picking Top-Quality Hedge Funds

By Arturo Neto AAA

With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions. Search guidelines can be used as performance metrics to determine hedge fund consistency over time, and to evaluate the guidelines themselves to determine whether the guidelines remain valid across different economic environments. Finally, guidelines can help third parties to better assist an investor in their search process. (Hedge funds don't sell themselves. Learn how marketing experts reel in the big fish in The Lucrative World Of Third-Party Marketing.)

Types of Guidelines
When looking for a high-quality hedge fund, it is important for an investor to define the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.

See: Hedge Funds

Absolute Performance Guidelines
The first guideline an investor should set when selecting a fund is annualized rate of return. Let's say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time. (To learn more about filters and screens, see Getting To Know Stock Screeners.)

This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long-short funds and several others. But if these aren't the types of funds the investor is looking for, then they must also establish a guideline for standard deviation. Once again, we will use the WGBI to calculate the standard deviation for the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.

Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds. (Learn how to apply this technique to choosing individual stocks in Peer Comparison Uncovers Undervalued Stocks.)

Now an investor has two guidelines that all funds need to meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund. (Learn how to evaluate additional investment types in How To Pick A Good Mutual Fund and Hedge Funds Go Retail.)

Relative Performance Guidelines
To facilitate the investor's search for high-quality funds that not only meet the initial return and risk guidelines but also meet strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund with a market-neutral, long-short equity fund.

To establish guidelines for a specific strategy, an investor can use an analytical software package (such as PerTrac, Morningstar or Zephyr) to first identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles, for that universe.

The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile. Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration. In addition, establishing the guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.

Putting It All Together
Here is a sound list of primary metrics to use for setting guidelines:

  • Five-year annualized returns
  • Standard deviation
  • Rolling standard deviation
  • Months to recovery/maximum drawdown
  • Downside deviation

These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis. An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze, or to identify funds that meet additional criteria that may be important to the investor. Some examples of additional guidelines include:

  • Fund Size/Firm Size - The guideline for size may be a minimum or maximum depending on the investor's preference. For example, institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face future challenges using the same strategy to match past successes. Such might be the case for hedge funds that invest in the small-cap equity space. (For more on this topic, read Mutual Funds: Does Size Really Matter?)
  • Track Record - If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate any new funds. However, sometimes a fund manager will leave to start their own fund and although the fund is new, the manager's performance can be tracked for a much longer time period. (Learn more in Should You Follow Your Fund Manager? and Your Mutual Fund: It's Riskier Thank You Think.)
  • Minimum Investment - This criterion is very important for smaller investors as many funds have minimums that can make it difficult to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors, while low minimums may indicate of a larger number of individual investors.
  • Redemption Terms - These terms have implications for liquidity and become very important when an overall portfolio is highly illiquid. Longer lock-up periods are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio-management process. A guideline may be implemented to eliminate funds that have lockups when a portfolio is already illiquid, while this guideline may be relaxed when a portfolio has adequate liquidity. (For more on this topic, read Five Quick Research Tips For Busy Investors.)

Conclusion
Setting up guidelines helps streamline the hedge fund search process by eliminating funds that should not be considered, and allowing an investor to focus their time performing due diligence only on funds that are worth evaluating. These guidelines can also assist third-party marketers or institutional platforms in targeting potential investors for particular funds.

For related reading, see Can You Invest Like A Hedge Fund? and A Brief History Of The Hedge Fund.

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