Hedge fund returns are determined by a manager’s skill-based investment and risk management processes. Because there are a wide variety of hedge fund approaches, each hedge fund produces a unique return stream, even if the underlying asset classes they invest in are the same. In contrast, traditional managers derive most of their returns from exposure to an asset class like equities or bonds, so their returns are more similar.

This variety in hedge fund return sources provides investors with powerful tools. By identifying high conviction hedge funds with specific return profiles, fund of hedge fund portfolios can be constructed to generate new return streams that are closely aligned with a client’s needs.

Further, because hedge fund returns display low correlation to each other, adding additional hedge funds to a portfolio can increase the quality of returns by decreasing risk while maintaining or improving overall return levels.

In short, these portfolio driven approaches can materially improve results from hedge fund investing in ways that are not available when investing in traditional managers.

In order to apply this portfolio driven approach, we must understand the connection between a hedge fund manager’s investment process, their performance, and the markets. Or in other words, understanding the complex and unique mix of correlations and risk factors present in every hedge fund.

Assembling this knowledge requires specialised investment staff, rigorous research and analysis, and strong analytical capabilities. With this knowledge, however, comes the ability to apply sophisticated portfolio construction techniques to maximise performance and produce new return streams that meet specific investor needs.

Not only is this knowledge critical for proper portfolio construction, it also enhances our ability to identify the best hedge fund managers and investment opportunities that will deliver the highest quality solutions and results.