The term hedge fund actually refers to a universe of 12 major investment strategies, which fall into four broad hedge fund sectors. These strategies are relative value, event driven, long/short equity and global macro.
THE FUND OF FUNDS APPROACH
A fund of funds (or multi-manager fund) is a fund that invests in a number of individual hedge funds (or single-manager funds). A primary benefit is diversification. A fund of funds will typically diversify across a number of different investment strategies, managers and styles. While diversification does not protect against loss of capital, it can help smooth the effects of volatility in any one single-manager hedge fund or strategy.
A key benefit of investing in a fund of funds is access to the expertise of a professional manager. A fund of funds manager takes responsibility for allocating across strategies and investing in underlying funds, while seeking to manage the risk/return characteristics of the portfolio. The manager also conducts the necessary due diligence and, importantly, continues to monitor the performance, risk and strategy of each of the underlying funds.
SINGLE-MANAGER MULTI-STRATEGY FUNDS
A single-manager multi-strategy fund's primary differentiation from a hedge fund of fund is that it has an investment philosophy of allocating capital to a variety of investment strategies run by internal investment teams. By definition multi-strategy funds engage in a variety of investment techniques but are often built on a core competency such as convertible bond arbitrage or equity long/short.
Many single-manager multi-strategy funds were born out of a need to increase capacity in their funds as their primary alpha driver was reaching capacity. The hedge fund wanted to attract new capital and thus had to develop new sources of alpha, unrelated to their existing capability, and hence a multi-strategy fund is born.
Multi-strategy funds can offer investors a diversification benefit as investment risk is spread across several strategies.
THE POTENTIAL ADVANTAGES OF INVESTING IN A FUND OF FUNDS
A fund of funds can invest in a wide range of hedge fund strategies enabling it to reduce the portfolio's volatility and enhance the potential for consistent returns.
Individual managers are often closed to new investors, and they generally have high minimum investment requirements. A fund of funds, however, may already be invested with these managers, offering access at an investment level well below the manager's normal minimum.
Consider the following criteria when evaluating providers of funds of funds: . A well-established firm with a solid infrastructure;
. A rigorous due diligence process for selecting and monitoring hedge fund managers;
. A disciplined allocation process for building portfolios; and
. Reasonable investment terms.
OUTLOOK FOR 2007*
As global markets adjust to a new interest rate regime, we expect financial markets to remain in a transition period and offer continued volatility. Volatility provides opportunities for hedge fund managers and historically has been a time of profit for the asset class.
We believe that out of the four major hedge fund sectors - long/short equity, event driven, relative value and global macro - that the first two, long/short equity and event driven, will offer the greatest opportunities for adding alpha in the near future.
Opportunity exists in the long/short equity sector despite the pull back in global equity markets over the northern hemisphere summer. We continue to believe seasoned stock-pickers, who employ fundamental analysis, will have an opportunity to generate alpha on both the long and short side.
In the event-driven sector we believe, as we did in the second half of 2006, that opportunities remain strong, as corporate balance sheets remain robust and coupled with the declines in some equity prices may offer attractive opportunities for acquirers, private equity and activists.
In 2007 our belief is that there is value to be added in each hedge fund sector, especially as the volatility in global financial markets continues. This year, regardless of the direction of general equity markets, will provide opportunities for hedge funds to make profits and thus returns for investors.
*Source: Topiary Fund Management, a subsidiary of Deutsche Asset Management.
