The 40% Solution to Hedge Fund Investing

Hedge fund indexers have borrowed from this concept, with many of them stating that to replicate the returns of the more popular alternative benchmarks, an allocation to only the largest managers is necessary. But in the real world, this approach means using only the largest available funds, since the best and brightest are closed to all but the most connected investors.

And then there is the heterogeneity problem. Performance of funds within the same sector is alarmingly different, especially within such a disparate strategy as equity market neutral, where the difference between the haves and the have-nots can vary by 10% to 20% in a given year.

At the fund of funds investor level, it all comes down to cost. Are indexed hedge fund products, which usually charge about 2% per year, a better deal than actively managed funds of funds and their 1% management/10% incentive fee levy? According to a recent study by Jimmy Liew of Carlyle Asset Management, about 30% of all hedge funds generate significant alpha. If an active FoF manager can maintain a hit rate of 40% (i.e., 40% of his portfolio is composed of alpha-producing managers), the additional fees are more than offset by enhanced performance. Whether this statistic puts the onus on the active or passive side remains to be seen.

The hedge fund indexing game is so new that picking winners and losers at this point is fruitless. In my experience, the best returns in hedge funds come to those that have access to proven talent. For this reason, I'd be inclined to choose an actively managed fund with a good stable of managers and a respectable tenure over a low-priced alternative.