Ways to Manage Hedge Fund Risk

Proceed with caution before investing in any hedge fund.

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Investors choose to place money in hedge funds to diversify their portfolios with assets that are not highly correlated to other investments. That’s the promise of a hedge fund -- to provide steady returns independent of other investments. In reality, hedge fund investors have historically been prey to a variety of risks. As an investor, you can manage your hedge-fund risk by being aware of different risks and taking steps to mitigate each one.

Liquidity Risk

Hedge funds are pooled investments that might trade in exotic financial instruments -- ones that are hard to sell on short notice. This is called illiquidity. Hedge funds don’t want investors withdrawing money at inopportune times, forcing the fund to sell off illiquid assets at a loss to raise cash. Therefore, funds might limit your access to your investment with various techniques to delay your withdrawals. You should carefully compare partnership agreements from a number of funds to find the ones that have the most liberal withdrawal provisions.

Strategy Risk

Hedge funds regularly employ more than a dozen major investment strategies. Typically, a fund has one trading desk for each strategy it follows and offers separate funds for each strategy. Investors can therefore select certain strategies and avoid others, depending on their personal risk preferences. For instance, a strategy based on mergers and acquisitions might seem riskier to an investor than a different strategy based on, say, the best and worst performers in an industry. It helps to educate yourself on hedge fund trading strategies and stick to ones with which you feel comfortable.

Performance Risk

Even the best funds have bad years. You can diversify your investment risk in hedge funds by instead investing in a fund of funds (FOF), which divides your investment among a number of hedge funds in the hopes that a bad performance by one fund will be offset by a winning return from another. FOFs add yet another layer of fees to the already steep ones charged by hedge funds, but the justification is that a FOF does due diligence in picking the hedge funds to include in its portfolio, choosing ones that have good management and unusual expertise.

Fraud Risk

Many people were wiped out when the Madoff Fund was exposed as a Ponzi scheme. There are a few precautions you can take to avoid being suckered in, but the risk is always there. To minimize the risk, you need to receive and read you periodic account statements to see if they make sense. Returns that never go down or seem too good to be true are suspect. Check the accounting and auditing firms used by the fund. Are they known and respected? Contact them to confirm they do indeed provide services to the hedge fund. Finally, check the backgrounds of the hedge fund’s officers for any past shady episodes.