Hedge fund selection is a crucial decision for any investor, particularly when considering a fund of funds portfolio. With an increased interest in alternative investments, the risk involved in hedge fund selection has become a major concern for investors. Not only does the investor need to understand the strategies in which the hedge fund specializes, but they must also be aware of the risks associated with the selection.
This article will explore the selection process for a fund of funds portfolio and how investors can minimize the risk involved. It will discuss the steps of selecting the right hedge fund and how to properly evaluate the fund’s performance
It will review the different types of risk associated with investing in hedge funds, such as market volatility and liquidity. By understanding the risks, investors can make more informed decisions when selecting a hedge fund and ensure they are making the best possible decision for their investment goals. Lastly, it will cover how using hedge fund outsourcing services can be beneficial.
What is a Fund of Funds?
A fund of funds (FOF) is a type of fund that invests in other funds. This is done in order to gain diversification as well as increase the amount of investment capital that a fund manager has at his or her disposal. Typically, a hedge fund will select a fund of funds in order to diversify their investments. A FOF will then select other investment funds to create a well-rounded portfolio.
Investors will typically select a FOF in order to gain access to a broader range of hedge funds and increase their diversification. As a result, an investor will select at least one, but frequently multiple, FOF.
A FOF is a good option for investors who are interested in alternative investments but are wary of investing in one specific fund. With a FOF, the investor has multiple funds at their disposal and is able to gain the benefits of diversification.
The Selection Process for Fund of Funds
The selection process for a fund of funds differs based on the investor and the fund of funds. For the investor, the selection process typically begins with understanding their investment goals and risk tolerance.
Five steps for selecting the fund of funds
1.Quantitative analysis
The first screening can be done with quantitative ratios that provide a clear-cut indication of the best funds. This step employs the following ratios and indicators: alpha, up and down capture percentages, omega, downside volatility, maximum drawdown, the Sharpe ratio, the Treynor ratio, and the information ratio.
2.Assessing the performance factors
This will include comparing the funds that have similar characteristics and follow the same investment strategy. The other factors include sector and country weightings, currency exposure, asset allocation, and market capitalization.
3.Qualitative analysis
Once the investor has narrowed down their choices, they should conduct a review of the fund of funds to understand its structure, team, and fees. At this point, the investor will be fully prepared to select their preferred fund of funds but must also be aware of the risks involved in hedge fund selection.
Some of the qualitative factors that every hedge fund administration services provider analyses are the fund’s portfolio team, additions and deletions in the team in the last year, compensation of the team, the buy-and-sell approach, etc.
4.Analyzing the portfolio strategy
After that, it is important to analyze the investment thesis of the fund. This includes selecting the funds based on their investment strategy, investment focus, and manager experience.
The fund of funds will then diversify their hedge fund portfolio by selecting funds for different investment strategies and focus areas. The portfolio strategy analysis includes knowing the competitive advantage a fund holds as compared to its competitors, its valuations, and the relative attractiveness of the asset in it.
5.Continuous due diligence
Lastly, they should conduct a thorough due diligence process like a hedge fund back office, including researching the fund of funds as well as the top hedge funds in the FOF. The investor also needs to understand their investment restrictions as well as the investment minimums for their funds.
Lastly, they should conduct a thorough due diligence process like a hedge fund back office, including researching the fund of funds as well as the top hedge funds in the FOF. The investor also needs to understand their investment restrictions as well as the investment minimums for their funds.
Evaluating the Hedge Fund’s Performance
Here is the list of factors that need to be analyzed to measure the hedge funds’ performance over the last few years, as every fund administration service does:
1.Check the fund’s investment objective!
The first step in evaluating the performance of a hedge fund is to understand the fund’s objective. The investor must know the fund’s investment strategy as well as its investment focus.
2.Evaluate the fund’s track record!
Once the investor understands the fund’s investment objective, they should review the fund’s track record. The track record will tell the investor how the fund has performed in the past as well as provide insight into future performance.
3.Analyze the funds that comprise a single FOF!
It is important to remember that the past performance of the fund does not guarantee future results or performance. It is also important to look at the funds that comprise the fund of funds. Sometimes, a fund of funds will include multiple hedge funds, and investors must include performance reviews of those funds in their analysis of the overall fund.
4.Analyze the fund’s returns!
This is also important because the performance of a hedge fund is based on the fund’s returns. Therefore, an investor must understand how the fund’s returns are calculated in order to properly measure its performance.
Types of Risk Involved in Hedge Fund Selection
Many investors are surprised to find that selecting a hedge fund is much more difficult than simply choosing the fund with the best returns. A hedge fund selection is generally a risk-reward decision.
The investor must understand the risks to decide if the investment is worthwhile or take help from the family office services that are experts in knowing the risks associated with the hedge fund. There are a number of risks involved in hedge fund selection, including market volatility, liquidity risk, and fund manager risk.
1.Market volatility:
Market volatility refers to the risk that the entire market is facing, and it is a risk that applies to all investments. There are a lot of factors that can affect the performance of the fund, such as inflation, political situations, fluctuations in interest rates, etc.
2.Liquidity risk:
Liquidity refers to the ability to sell the investment at the desired price. Liquidity risk refers to the risk associated with the fund not being able to be sold in the future at a fair price.
3. Fund manager risk:
Fund manager risk refers to the risk that the fund manager will make poor investment decisions. The risks associated with the fund manager are fraud or moving away from the fund’s mentioned strategy.
Strategies for Minimizing Risk
With these strategies in mind, investors will be able to make a more informed decision and minimize risk when selecting a hedge fund.
1.Diversification:
The best strategy for minimizing risk when selecting a hedge fund is to diversify the hedge fund portfolio.
2.One that matches with the risk appetite:
Investors should only consider hedge funds that fit their investment objectives and risk profile. Investors should only invest in the funds that they are confident will be successful.
3.Knowing the risk:
Investors should be aware of the risks associated with hedge fund selection and understand the strategies that the fund specializes in.
4.Knowing the cost of the fund:
Investors should pay attention to the fees associated with the hedge fund, as well as the fund of funds.
Benefits of Hiring Outsourced Hedge Fund Service Providers
Benefits of choosing hedge fund administration services
The fund managers all over the world are moving to the third-party fund administration which helps in managing and selecting the best hedge funds from the multiple options.
1.Increases the level of diligence
Hiring a hedge fund back office outsourcing firm will help add an extra layer of diligence to checking the fund’s performance and management.
2.Cost benefits
The third-party firm will help during the time when fees and margins are high and will also provide cost-efficient solutions for the management of the in-house team, training, and recruitment.
3.Access to automation
Hedge fund back-office services are fully equipped with automated technologies to provide the most digitized way of analyzing the changes in the fund and also provide a robust portfolio accounting system, an investor portal, and a client self-service portal.
4.Expertise team
They also have a team of professionals who constantly monitor the fund’s operations and the assets they invest in daily.
5.Compliance
Hedge fund middle office services and back office not only fulfill all the risk management and tracking needs but also fulfill the statutory and compliance work on the client’s behalf with the utmost accuracy and on time.
6.Scalability:
The family office outsourcing firms provide the services on demand, which can be easily scaled up or down based on the clients’ requirements.
Conclusion
Fund of funds, like other investment vehicles, are purchased by investors based on their risk and reward profiles. A fund of funds’ selection process begins with researching, selecting, and then constantly monitoring the hedge funds in their portfolio. Hiring the right fund administration services, such as IBN Tech, will do the risk and quantitative analysis of the fund of funds (FOF) and save your time on non-core operational work.
