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A Hedge Fund Chronology continued...



Part three: Final Installment

see Part one or Part two.

In my opinion, generally Funds of Funds lack the day to day, year to year experience in analyzing risks appropriately. If they have this experience (they would probably need an ex-hedge fund manager on hand to do this), they do not have the full transparency (ability to look at every position in the portfolio) to make an accurate assessment.

Another problem with Funds of Funds is that they cannot re-allocate from or into hedge funds quickly. There is always a period, normally three months, where they must give notice to the underlying hedge fund to liquidate their investment. If there is a cause for concern either because of market conditions or due to an individual manager or fund, they are stuck at least for a while.

One solution to this problem has been the emergence of multi-strategy hedge funds. These are hedge funds that hire different managers of specialized expertise, each running a different portfolio, and manage them under one roof. The fund then allocates external investor money among these funds. In theory, this allows funds to be moved around more efficiently. In practice, it really does not work that way.

First of all, each manager basically has their own fund. A convertible bond manager under the management of a multi-strategy fund is still motivated to stay invested because they are compensated on their own performance. And that manager can accept an investment directly into his own sub-fund. Here there is no possibility of moving that capital into another sub-fund if the space becomes unattractive.

In addition, there may not be any formal overall risk control from the bottom up, in which case each manager is left to control their own risk. This is a very inefficient and potentially dangerous way to run risk. In addition, the manager does not care about other managers' performance, other than for money raising purposes; therefore, the manager has a strong incentive to remain fully invested at all times.

I believe there are some funds that have correctly solved this problem by having an overall risk manager and compensating all managers on the performance of the overall fund.

Although we have only two primary portfolio managers (my partner started in the business with me at Morgan Stanley back in 1982 where he ran trading for international convertible bonds), we have five analysts each of varying responsibilities: fundamental equity, technical analysis, legal/risk arbitrage, macro economics, and volatility. These analysts advise us on various opportunities in their space. The result is one portfolio comprised of different offensive positions, but run together for risk purposes.

Everyone is compensated for the overall performance of the fund, not on any particular part of the portfolio. This allows everyone to be intellectually honest about their space. As you could probably tell from the above example where we might use one space for offense and another for defense, unlike most multi-strategy funds that allow an investor into one particular sub-fund, we would not allow this. Our investors invest in the overall portfolio where we allocate to opportunity and adjust for risk.

NOTE: Please understand that this is not a solicitation of any kind. We share the process with you for the sole purpose of education.

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