Hedge Funds and Market Meltdowns

Those who were invested in hedge funds in the fall of 1998, a period that witnessed the demise of Long Term Capital Management and several other unfortunate parties that were active in emerging-market bonds, might have a different opinion. But this disastrous event only proved that problems at one financial institution can be transmitted to other institutions. After all, troubles at one money-center bank are almost always felt at every address on Wall Street.

The extreme heterogeneity of hedge funds supports the notion that alternative investments are too broad in scope to be considered an asset class. If that is the case, hedge fund investing should be considered a bottom-up exercise. An investor trying to decide between a number of convertible bond arbitrage funds, for example, should weigh firm information more than the return attributes of the strategy itself.

There are some exceptions to this rule. Trend-following futures funds tend to move more in lockstep with each other than do other hedge fund styles, and there are a number of indexes that capture the return of the strategy quite well. But considering the move by many large firms to a multistrategy platform, due diligence at the manager level will likely become an increasingly important part of the allocation process.