Investment mandates for hedge funds

Hedge funds were originally developed to provide a high-risk, high-return investment supplement for wealthy and, presumably, sophisticated investors. Eye-catching returns contrasted in recent times with disappointing results from conventional funds, which led many pension fund managers to seek ways to share the superior returns offered by hedge funds. If well selected and implemented, hedge funds can both add return and reduce volatility in the overall funds. Poorly planned and executed hedge fund investment can expose the fund to extremely high costs, low liquidity and potentially unknowable investment risks. Perhaps the worst danger is that the investments in the hedge funds offset those of the conventional fund, resulting in a bland overall mix that has no chance of achieving the hoped-for returns, but with high fees. Recent forecasts by economists of more modest returns from equities and bonds for the foreseeable future pose potential problems for managers of retirement funds. One solution is to add high-return investments, such as hedge funds, to the portfolio mix. The paper describes some popular hedge fund strategies, and how they may complement a conventional balanced portfolio. It then explores ways to select from the wide range of hedge funds available and choose a hedge fund that will add value without compounding or offsetting the risks within the existing fund. The potential role of indexation in combination with hedge funds is discussed, together with some approaches to risk analysis.