Ten Common Mistakes Investors Make When Allocating to Hedge Funds

In a paper, Francois-Serge Lhabitant identifies the "ten most common mistakes" that investors make when allocating to hedge funds:

1) Targeting Decorrelation: Investors often seek hedge funds that are uncorrelated with traditional assets. However, this can be misleading as correlations are often misunderstood and do not necessarily predict future returns.

2) Using Hedge Fund Indices: Many investors rely on hedge fund indices, which are often distorted and unrepresentative. These indices often do not offer true alpha and are over-diversified.

3) Minimizing Fees: While high fees are criticized, low fees often result in less qualified managers. It is more important to focus on net returns rather than the level of fees.

4) Choosing High Sharpe Ratio Funds: The Sharpe Ratio measures risk-adjusted return, but focusing solely on high Sharpe Ratios can be misleading. A combination of funds with high Sharpe Ratios does not necessarily result in a better portfolio.

5) Behaving Like a Hedge Fund Manager: Investors should not try to time hedge fund managers or choose managers who share their own market views. Instead, they should select high-quality hedge funds and leave tactical decisions to the managers.

6) Over-Diversifying: Too many hedge funds in a portfolio can lead to alpha dilution and increased market risk. A targeted selection of hedge funds is more effective.

7) Underestimating Short Volatility Strategies: Some hedge fund strategies resemble selling put options and involve significant risks. These risks must be recognized and, if necessary, hedged.

8) Neglecting Operational Due Diligence: Many investors skimp on operational due diligence, leading to avoidable losses. Thorough scrutiny is essential.

9) Using Static Linear Models: Linear regression models do not capture the complexity of hedge fund strategies. Alpha calculations are often misleading as they do not reflect actual risk profiles.

10) The Power of Pie Charts: Traditional asset allocation charts are not suitable for hedge funds. A flexible and differentiated approach is required to consider the unique strategies and risks.

By avoiding these mistakes and conducting thorough due diligence, investors can improve their chances of successful hedge fund investments.