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The Darwinian theory of hedge fund evolution

In any market, the longer a sustained bull run continues, the lower the average quality of a manager becomes.

In any market, the longer a sustained bull run continues, the lower the average quality of a manager becomes. In addition, once single-country funds in particular grow above their optimal size, they lose the ability to move as nimbly as they once did and become more constrained in their investment practice.  

With a complex and ever changing market, the process of evaluating a manager’s suitability for inclusion in a fund of hedge funds requires a strong local presence and extensive investment experience coupled with a rigorous research process. Investors new to the region, or to hedge funds, are unlikely to be able to afford to build the necessary infrastructure for themselves, or may not even want to do so.

The new mantra, then, is early identification of creative and innovative hedge fund managers. An experienced fund of hedge funds manager with a well-structured investment process that includes multi-layered risk management capable of addressing investment, portfolio, operational, process and opportunity risks, can offer a more practical and cost-effective solution to identifying and investing in promising emerging managers and their developing strategies. 

Many might question the risk involved in investing in new managers. However, this can be minimised by making a relatively modest initial investment and the reward can be enhanced by growing the scale of investment quickly while the manager’s exploitable edge remains at its sharpest. Identifying a promising new manager and making an appropriate investment is only part of the story.  Knowing when to exit an investment is what sets apart a really good fund of hedge funds manager.
 
At GAM we believe that active investment management is a vital ingredient for long-term success when investing in hedge funds.  All our research suggests that hedge funds display limited persistency in performance.  As a result, investors basing their decisions purely on historical data are likely to be disappointed.  Our fund of hedge fund investments are driven by bottom-up research and close monitoring of allocations to ensure that each fund delivers in line with, or above, expectations.  Rigorous research is critical and our extensive investment in this process and the breadth of our analysis continues to develop, allowing us to gain better insight into hedge fund strategies and, specifically, hedge fund managers.  Further, GAM’s gradual approach to early stage investing ensures that only limited risk is passed on to our investors, while allowing us to build strong relationships with a wide array of managers. This is also supported by a due diligence and monitoring process, conducted by an independent team.

A degree of concern has been expressed in recent months about the apparent growing correlation between the returns from hedge funds and more traditional forms of investment.  To some extent, that concern is somewhat exaggerated and misguided. The hedge fund industry is a perfect example of the Darwinian theory of evolution and in this context it becomes increasingly important for hedge fund managers to continue to identify new investment opportunities and for fund of hedge funds managers to track their changing strategies if out-performance is to continue. Only the fittest survive.

David Smith, Chief Investment Director of GAM Multi- Manager

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