Mercer Report: Hedge fund industry faces 2006 performance challenges, but weathered a tough 2005 well

The 2006 outlook for the hedge fund industry looks challenging, following what will be remembered as a tough 2005, reports Mercer Investment Consulting, Inc.

In its latest hedge fund newsletter, Mercer notes that last year, hedge fund managers faced a difficult market environment marked by low volatility and low risk premiums and several scandals brought the industry unwanted attention.

Despite these serious challenges, the hedge fund industry has demonstrated remarkable resilience, as assets are firmly above USD 1 trillion by all accounts.

In order to avoid being harmed by accounting shenanigans, investors must ask tough questions up front and spend more time on operational due diligence, said Jeff Gabrione, a Chicago-based senior consultant with Mercer IC who specializes in hedge funds.

Need for increase in non-investment due diligence

"By some accounts, up to 50 per cent of all hedge fund collapses are the result of operational failures, particularly misrepresentations, misappropriations of funds, and unauthorized trading," Gabrione said. "Investors were reminded of the important role that non-investment due diligence plays when selecting hedge funds and the need for them to fully integrate operational issues into the investment decision-making process."

Non-investment due diligence includes accounting practices and valuation methods; legal structure, regulatory, and compliance policies; trading, settlement, and execution procedures; human resource practices; implementation of technology; review of service providers; and management and governance practices.

Focus on placing funds of hedge funds within diversified strategy

In order to deliver the level of returns necessary for many actuarial assumptions, some investors will consider specialized, or focused, fund of hedge funds instruments. Most investors rely on a diversified fund of hedge funds approach. Sometimes they require more upside return potential than the broad strategy offers but cannot accept leverage. Focused funds of hedge funds serve this need while preserving some of the benefits of a broadly diversified approach. While these funds come in many different varieties, the most popular are market neutral and equity long-short products.

"This specialized strategy can serve either as a complement to a broadly diversified strategy or as part of a portable alpha program," Gabrione said.

An investor gets the risk-mitigating benefits of the fund of hedge funds structure, but can better match specific risk-return considerations than a traditional, broadly diversified fund of hedge funds. "Similar to other investment decisions, investors must be comfortable that the manager has expertise within this specialty," added Gabrione.

Need for proper benchmarking

After a year when hedge fund returns overall seemed disappointing relative to past performance, Mercer IC stresses the need for benchmarking managers.

"Over a three-year period, successful managers ought to attain their stated targets," said Gabrione. "Peer comparisons are the next most effective means of benchmarking performance. Finally, investors can compare the hedge fund's performance to an index for a rough gauge of opportunity cost, although we do not advocate it as the sole benchmarking metric. Ultimately, the decision to hire or retain a manager comes down to more than performance, but proper benchmarking makes the decision easier."

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