While it might be true that no investment is inherently imprudent, some start with a presumption of guilt until proven innocent. Hedge funds fit into this category because of the inherent hurdles they present to fulfilling a fiduciarys duties to their client.
Fiduciaries contemplating hedge fund investments should subject themselves to hypothetical cross-examination before taking action. The following line of questions illustrates how established principles of fiduciary responsibility apply when considering the appropriateness of hedge fund investing.
1. Are you permitted to hold this type of investment? The fiduciary must fully understand the rules that guide management of the portfolio. Laws, regulations, trust documents, the investment policy statement and other instruments of authority might have provisions that would preclude hedge fund investing. For example, restrictions regarding the use of derivatives, margin or securities lending would routinely rule hedge funds out.
2. Do you believe financial markets are inefficient and that such inefficiencies are exploitable? The bedrock fiduciary principle of investing is diversification. That principle is based upon the presumption that markets are generally (if imperfectly) efficient. The indisputable focus for prudent management of risk and return should be to establish and maintain a core policy portfolio of asset classes. Pursuit of alpha, or exploitation of possible market inefficiencies, is permissible, but not at the expense of proper emphasis on the policy portfolio. Hedge fund investing explicitly focuses on finding market inefficiencies that are essentially imperceptible or inaccessible to others. Is this possible to accomplish consistently over an extended period of time? Academic research is inconclusive. Before proceeding with your hedge fund investment, study the research and be prepared to articulate a philosophy regarding the strength of market efficiency. If you cant convince yourself of exploitable market inefficiencies, avoid hedge funds.
3. Can you adequately evaluate the positions held in the hedge fund investment and the associated risks of those positions? Hedge funds are generally non-registered, non-transparent vehicles. Given that the manager can only succeed if he can find market inefficiencies that are essentially imperceptible or inaccessible to others, secrecy is essential. As a fiduciary, you must have the time, inclination and ability to perform enough due diligence on the investment to choose among hedge funds and to craft a loss-limiting strategy for the position. If you dont have the time, inclination or ability to accomplish this, you must hire an expert to do it or pass on the hedge fund idea.
4. Are the fees and expenses of hedge funds fair and reasonable? This question addresses the fiduciary responsibility to account for and control expenses. In the case of hedge funds, the issue boils down to whether there is likely to be enough extra return (alpha) to pay a 2-and-20 fee structure and have enough left to make the investment worthwhile. Hedge fund fees are high, generally 2% of assets under management and 20% of profits after having achieved a benchmark return. Add the cost of managing points 1 through 3 above when you do the cost-benefit analysis. If the net expected alpha isnt a large positive number, dont invest. If it is a large positive number, review whether projected returns are reasonable and recheck your math; large positive net alpha is exceedingly rare.
5. What recourse do you have if something goes wrong? Are the assets within the jurisdiction of U.S. courts? The assets of most hedge funds are held in off-shore custodians. The No. 1 location of custody is the Cayman Islands. Ask your hedge fund provider about recovery in the event something unseemly should occur.
Only after you have considered these questions and conclusively proven that your fiduciary duties are being met can you feel comfortable in selecting hedge fund investments. Fiduciaries operate in a special relationship of trust and legal and ethical responsibility for managing the money of others. When it comes to hedge fund investing, the obligations attendant to the fiduciary role point directly to the line of inquiry presented above. In my view, the hurdles that must be cleared to justify making hedge fund investments are too high for most fiduciaries. Those that do decide to proceed down the hedge fund path should be prepared to demonstrate that they did so properly by having a compelling case for their conduct prepared in advance.
Blaine F. Aikin is managing partner and chief knowledge officer of fi360, Sewickley, Pa.