DUBAI, 27 October 2003 — In recent years the number of hedge fund providers as well as the variety of hedge fund investment styles available to investors has increased significantly. While there has been an increase in choice, the task of choosing a hedge fund product has not become any easier. In an effort to attain the attributes that hedge funds add to a portfolio many investors, both private and institutional, have chosen to minimize their exposure to any single manager or product and have opted for fund of hedge fund products.

Composition of a Fund of Hedge Funds

The construction of any successful fund of hedge funds product is highly dependent upon the skill of the investment manager. The manager must have the experience and the resources to successfully identify the most promising hedge funds from the estimated 5000-6000 in existence. Proprietary databases are often used to filter down to the most appealing candidates. Prospects are further distilled using a mixture of quantitative methods, such as analyzing annual returns, and qualitative processes based on industry intelligence gathering.

Once the initial screening process has been completed, a due diligence process examines the hedge fund at the individual, organizational, operational and strategic level.

Managers that pass the stringent requirements are placed on an approved list that is then used for portfolio construction. Due to the diversity of existing hedge fund strategies, managers are typically included that have minimal correlation to one another.

It is the judicious diversification across managers, rather than simply selecting a group of the most talented, which leads to greater returns per unit of risk. Different market conditions favor different strategies and performance of funds can vary widely depending on their approach.

Identifying Fund of Hedge Funds Managers

With so many hedge funds trying to find profit opportunities in overlapping markets, superior processes and skillful application will separate the successful fund of hedge funds managers from the mediocre.

An investor that uses a fund of hedge funds manager is essentially paying a quality premium, but should be careful to ensure that they are getting what they pay for. Among the criteria that investors need to adhere to when selecting fund of hedge funds managers are industry experience, process quality, and extent of network.

It is imperative that the fund of hedge funds manager knows all aspects of the hedge fund industry. This requires a profound understanding of all hedge fund strategies as well as all instruments used by hedge funds. In addition, they also need to have acquired this experience over a lengthy period, to appreciate the benefits of various strategies at different points of the market cycle. The fund of hedge funds operation involves quantitative as well as qualitative processes and projections. In addition it requires the knowledge, insight and experience of getting a qualitative interpretation of the quantitative analysis. The whole process is iterative because there is no beginning or end to the process of manager selection, portfolio construction, risk monitoring and portfolio rebalancing. This requires considerable resources and capability.

Being in the position of spotting talent early is a competitive advantage. A fund of hedge funds manager has to be inside the prime information loop of the business. This will enable them to spot talent early in the evaluation process. Some fund of hedge funds managers are able to identify and track skilled investment professionals before they announce that they are launching a hedge fund. A fund of hedge funds manager who has superior information on key staff in the main investment centers will have a competitive advantage. Some of the most talented managers close their funds to new money early and only raise capital among existing investors. An edge in the search for talent could potentially be the single most important performance driver of a fund of hedge funds operation.

Conclusion

Hedge funds are robust instruments that provide valuable diversification away from the risks inherent in an over-concentration of capital in traditional assets. As fund of hedge funds managers operate in a market as inefficient and opaque as the hedge fund industry, they have a strong value proposition.

The success of any hedge fund product is highly dependent upon the skill of the investment manager and therefore it is crucial to select a manager with a clear competitive edge. Investors should look for an investment manager with considerable experience in the hedge fund industry and a proven ability to construct and manage a hedge fund portfolio.

(Antoine Massad is head of Middle East and Asia of Man Investments.)