To understand hedge funds and why they have historically outperformed traditional methods of investing, investors should understand the significant differences between hedge funds and traditional asset management in:

• Organisational Structure: hedge funds have structures which align investors, managers and owners around goals of return maximisation and capital protection. Because manager and owner capital is invested alongside investors, hedge funds have strong incentives to actively manage downside risk. This differs from other forms of financial institutions in which the interests of investors, managers and owners may differ, leading to underperformance or excessive risk taking.

• Risk and Return: traditional managers deliver the majority of their returns from exposure to asset classes such as equities or bonds. Hedge funds are fundamentally different – deriving the majority of their returns from skill-based risk management and investment processes. Hedge funds and traditional managers also differ in how they define risk. To a traditional manager, risk means tracking error versus a market benchmark. To hedge funds, risk means any kind of loss as they actively attempt to manage downside exposure.

• Investment Tools: traditional asset managers tend to only trade one asset class, in one market, and generally only have long exposure. In contrast, hedge funds will trade in any market, any asset class, and any type of security to generate returns. They will go both short and long, attempting to profit from price movement in either direction. Some use leverage to adjust risk levels in response to opportunities. Because they are not trying to track market indices, they can invest in their best ideas and can actively manage downside risk.

• Dynamic and Unconstrained: hedge funds are adaptive and unconstrained in their pursuit of superior investment opportunities. This dynamic and flexible nature of hedge funds is key to their ability to produce superior returns on a consistent basis. However, from an investor’s perspective, it requires skills and resources to understand and constantly

monitor the manager’s holdings and process.

• Dispersion of Returns: in addition to attractive returns, hedge funds bring substantial benefits because of their diversification properties. Hedge funds often have low correlations to each other and to market indices. This is a direct result of managers producing returns from a variety of unique investment strategies, rather than from exposure to asset classes.

The variety of hedge fund return streams means there are substantial benefits to portfolio driven approaches to investing in them. Fund of hedge fund portfolios can improve the overall quality of returns and provide a method for creating new return streams that more closely address investor needs.