If you want to build a hedge fund program, you can study a report issued ten years ago by the Investors’ Committee to the President’s Working Group on Financial Markets.
To assess the appropriateness of a hedge fund program, questions prudent fiduciaries should consider include, but are not limited, to the following:
- Temperament: Do we, as an organization, have a suitable temperament for investing in innovative strategies? Without the comfort afforded by long-term practice and empirical evidence, do we have the institutional fortitude to stick with our strategic allocation in the face of short-term volatility?
- Manager Selection: Do we have qualified staff that can reasonably detect true investment skill and the non-obvious sources of risk inherent in hedge fund strategies? The answer may depend on the particular investment strategy. Can we allocate sufficient resources to manage and monitor new hedge fund investments and existing investments effectively? If the answer to either question is no, do we have the ability to assess, select, and engage appropriate intermediaries to whom we can delegate the evaluation of hedge fund management and its strategies and execution?
- Portfolio Level Dynamics: Do we understand the way in which our proposed hedge fund portfolio will generate investment returns? Are our return assumptions reasonable in the context of the market? Do we understand the risks involved in the proposed hedge fund portfolio in the context of our overall portfolio? What part of the total risk comprises systematic risks that are not diversifiable, as opposed to idiosyncratic risks associated with particular investments? In what scenario would the overall hedge fund portfolio likely underperform or outperform its expected returns? Do we understand the types and degrees of leverage embedded in the proposed portfolio? Do we understand more generally issues of counterparty credit risk embedded in the proposed portfolio?
- Liquidity Match: Is the liquidity of the hedge fund portfolio consistent with our needs as an organization? To what extent could short-term behavior by other investors undermine our advantage as long-term investors?
- Conflicts of Interest: Have we identified and addressed actual, potential, or apparent conflicts of interest arising from our hedge fund program? Have we taken appropriate steps to eliminate or mitigate adverse consequences arising from these conflicts of interest?
- Fees: Are the fees associated with the hedge fund investments generally reasonable in the context of the market? For given levels of realized return, what percent of the gross return would go to the manager versus the investor?
- Citizenship: Do we, as an organization, feel comfortable that the hedge funds in our portfolio are good capital market citizens and are not engaged in objectionable practices? Even among high integrity managers, some strategies might be unpopular and subject to characterization in the press that may negatively impact our reputation; do we accept the headline risk that accompanies unconventional investments?
What is the President’s Working Group on Financial Markets?
According to Executive Order 12631, signed in March 1988, the Working Group was created to perform three clear jobs.
- They would “identify and consider” what had caused the 1987 financial crash, and work out which actions needed to be carried out.
- They would “consult, as appropriate, with representatives of various exchanges, clearinghouses” on behalf of the government to figure out what the private sector could do to help.
- They would report back to the president within 60 days, “and periodically thereafter.”
The committee is chaired by the Treasury secretary, and includes the Federal Reserve chair and the heads of the Securities & Exchange Commission and Commodity Futures Trading Commission, or their designees.
Post by Marcelino Pantoja