Guidelines for Modern Hedge Fund Investment Strategies
A New Paradigm for Hedge Fund Investing
A new era in hedge fund investing is upon us, as institutions and hedge funds recognize that the current investment ethos is not sustainable. This new paradigm, grounded in six core principles, promises better returns, lower fees, and a proper realignment of incentives.
The first principle is understanding that the underlying opportunity set drives performance. A portfolio split across typical strategies may not capture a constantly evolving market opportunity set. To address this, the new paradigm encourages expanding the universe of strategies and structures to achieve the same goal. Potential alternatives include UCITS/mutual funds, OTC swaps, and managed accounts.
The second principle is structuring fees appropriate to the investment strategy. Performance fees should only be charged above an appropriate hurdle rate, paid over multiple years, and declining as fund assets grow. This approach aims to ensure that managers are incentivized to generate long-term returns for investors rather than focusing on short-term asset gathering.
Employing liquidity as both an offensive and defensive weapon is the fifth principle. Liquidity can be used to reduce risk and capitalize on market dislocations. Allocators can take more risk with satellite investments due to the use of replication-based strategies, which provide synthetic diversification and minimize certain fat tail risks.
The sixth principle is rigorously examining biases in allocation. Biases such as recency bias, loss aversion, and anchoring can cloud judgment and lead to poor investment decisions. By understanding and addressing these biases, investors can make informed decisions about high and low-cost investment options.
The third principle is to target underexploited opportunities in middle-market credit, infrastructure, and direct investments where competition and inefficiencies remain. Market dislocations are a significant source of alpha over time, and these opportunities can help allocators capitalize on them.
The fourth principle is embracing lower cost alternatives when feasible. Replication-based and risk premia strategies offer much of the upside of actual hedge funds with just a fraction of the fees. This shift towards lower cost alternatives can help improve returns while reducing fees.
The new rules for hedge fund investing aim to make the next decade far more abundant than the last. The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group.
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[1] Source: Investment & Pensions Europe [2] Source: Preqin [3] Source: Institutional Investor [4] Source: Harvard Business Review [5] Source: McKinsey & Company
In this new paradigm for hedge fund investing, the expansion of the strategies and structures used is encouraged to capture evolving market opportunities, potentially incorporating UCITS/mutual funds, OTC swaps, and managed accounts. The structure of fees should also be appropriate to the investment strategy, ensuring performance fees are charged above a hurdle rate, paid over multiple years, and declining as fund assets grow, to incentivize managers for long-term returns.
