Alternative Investments: Hedge Funds

Not only are there many more hedge funds around than, say, ten years ago, when there were just 300 funds in the world, but also there is a growing industry of advisors who create products specifically for private investors. These products are designed to provide investors with cost-efficient and structured access to the alternative investment market. To understand why these products are of benefit, it is worth considering the pitfalls for the private investor of taking the single manager approach.

Provided the investor meets the appropriate regulatory criteria, it is possible to buy into individual hedge funds. But many individual hedge funds only accept a minimum investment, usually between US$100,000 and US$1 million, putting them well beyond the reach of most investors.

Moreover, investors who are seeking to optimize a portfolio will only place money in hedge funds as part of a diversified approach, with traditional asset classes making up the majority of the portfolio. If, for example, the investor decides to put 10% into alternative assets, that investor will need total capital of at least US$1 million to make an allocation to one single hedge fund. If the investor want to go to the next level, adding a diversified selection of hedge funds to the portfolio, the capital requirement becomes astronomical.

Hedge fund managers have traditionally set high entry thresholds partly for regulatory reasons, partly to limit the number of investors to their funds and partly because their strategies may not be able to support huge sums of capital. Many strategies - particularly in equities - are more efficient when they trade in small blocks of capital: this keeps trading costs low relative to returns and improves liquidity, both of which contribute to better performance. Some hedge fund managers actually quote a figure for maximum assets under management, or total capacity, indicating the point beyond which they are no longer efficient. It must also be borne in mind that most hedge fund management outfits are small operations, with a handful of staff, and therefore do not want, or are not able to offer extensive investor relationship contact with a large number of investors.

The subscription and redemption policies of many hedge funds are also often unfriendly for individual investors. Typically, investors can only enter or exit a fund on a quarterly basis. Moreover, there may be a lock-up period of a few years before the investor is entitled to redeem the investment. This is because the hedge fund manager wants a stable asset base.

In summary, the single manager approach is suitable for serious investors, who have large sums of capital they are able to lock-up for several years at a time. These investors will probably also need to be prepared for minimal contact from the fund manager.