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Multi-Manager or Direct: The Pros and Cons of Each Approach To Hedge Fund Investing in South Africa

Carla de Waal, CFA, head of funds of hedge funds and Marius Kilian, chief executive
Novare Investments
December 2011

The most important initial decisions for an investor are whether a hedge fund allocation is suitable for their portfolio and, if so, what the size of the allocation should be. It would be prudent to obtain expert financial advice when making this decision. The next step is how to access the opportunity set of available hedge funds, and here investors can choose to invest directly in one or more single-manager hedge funds, or use the multi-manager approach and invest in a fund of hedge funds. A fund of hedge funds is a diversified portfolio of individual hedge funds.

Dedicated and specialised skills

Going the multi-manager route means outsourcing manager selection, portfolio management and risk monitoring to a dedicated team. These functions require active management, for which funds-of-funds managers charge a fee. The investor needs to weigh up whether the benefits are worth the additional cost. In our experience, the main benefit of investing through a fund of hedge funds is the specialised level of governance that mitigates significant hedge-fund-specific risks, given that certain areas in the hedge fund space are still relatively unregulated.

In the hedge fund arena, risk management is a key aspect encompassing a host of factors that need to be continuously verified and monitored as part of a dedicated process. Hedge fund failures are more often than not related to operational issues rather than market factors. A weak operational set-up will also exacerbate the impact of market-related issues like tough trading conditions, even leading to an incapacity to deal with changes in the regulatory environment.

Operational risk may include inadequate technology or processes (infrastructure risk), which may lead to mispricing risk or the risk of a fund trading outside of its mandate. Operational risk also includes the risk of misrepresentation of investments, which is especially high when the fund manager is also involved in the valuation of the portfolio, and the risk of misappropriation of investments or outright fraud. Funds of funds managers typically verify the solidity of processes before investing and continuously monitor fund management teams and their operational set-up for any changes that signal increased operational risk.

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