Mercer: Jump Carefully into Hedge Funds

In its May 2004 Hedge Funds newsletter, Mercer Investment Consulting chronicled the explosion of hedge fund products with 6,000 to 7,000 such funds now operating in the U.S., according to one estimate, with the hedge fund market worth more than $1 trillion by 2014.

However Mercer researchers think that may be a bit conservative, which they said brings up another chance to caution institutional players not to forget the basics of carefully checking out the products into which they want to place money. “At the current rate of growth, we expect the market will reach (the $1 trillion mark) much sooner,” they wrote in the newsletter. “With so much money flowing in the hedge fund market and relatively low barriers to entry, undertaking a due diligence process is now more critical than ever in selecting the best fund managers.”

While Mercer said its client base has stepped a bit more carefully into the hedge fund area than other institutional players. However,   clients continue asking for more information about the product with search for fund of hedge fund selections – what Mercer said was its “preferred” way to take a hedge fund position – representing just over 2% of its total search activity, the newsletter said.

“Based on what we’re hearing from our clients, we expect initial allocations to grow over time as clients become more comfortable with hedge funds,” says John Frede, who heads Mercer IC’s U.S. Investment manager research group.

According to Frede, the most compelling reason to invest in hedge funds is to capture the alpha created through hedge fund manager skill – finding someone skilled to run a hedge fund mandate can potentially pay off in a big way. 

“Considerable value can be added by selecting the best managers within a particular style, rather than by investing passively in a benchmark that attempts to replicate a median manager proxy,” Frede said. “Actively managed fund-of-hedge-fund products typically are backed by a robust due diligence process that attempts to identify the most skilled managers. Ongoing monitoring of managers for drift of style, strategy, or assets is important.”

However, that raises another difficult issue facing institutional investors and other clients: how to benchmark hedge fund managers once an investment has been made, according to Frede.

“There are a number of approaches to benchmarking, including the use of index and peer comparisons,” Frede said. “But the best way, in our view, is to look at these in conjunction with manager objectives against historic performance, as a way of demonstrating whether targets have been achieved. The latter is one of the strongest methods for evaluating performance, because it requires a manager to provide realistic projections for a product and then achieve those promises over time.”

For more information about Mercer, go to www.MercerIC.com . A free registration is required.