06/27/2011 06:03 pm ET | Updated Aug 27, 2011

How to Handle Hedge Fund Investing

Whilst at GAIM, the largest hedge fund conference in Europe, it was hard to ignore both the issues the hedge fund industry face and the opportunities from which they can profit. So how can you, as an investor, handle hedge fund investing? Be strategic, be sensible and speak up....

Fees -- How can you challenge them?

Bigger isn't always better. Instead it was the larger funds that had trouble liquidating large positions to meet redemptions in 2008 and this was amplified in Fund of Funds structures. The resulting side pockets and gates, which locked up investor capital, burned bridges. Therefore, funds merely offering access to large 'star' fund managers with limited attention to downside and liquidity risks no longer appear to be as wise an investment as once perceived.

A due diligence downfall. Some funds of hedge funds had exposure to Madoff and other hedge fund failures. Therefore, 'outsourcing' hedge fund investment to a dedicated fund manager did not always reduce risk.

Strategy choice -- Does it matter?

A 'typical' hedge fund does not exist. A hedge fund index is an artificial averaging of a wide range of performance data. In fact, over the past couple of years, the best performing hedge fund strategy has generated 160% more return than the worst. Yes, 160%! Even year to year the rankings change. By investing in completely different assets, implementing vastly different investment processes, hedge funds can perform in entirely different directions in a variety of market conditions.

Value - How can hedge fund investments benefit your portfolio?

Well-equipped. With doubts over the sustainability of the 'recovery' in the developed world shaking equity markets; turmoil in the middle east creating volatility in commodities and the sovereign debt crisis rocking the bond markets, having a wider range of tools to exploit the uncertainty is valuable

A diversifier. Widespread fear and the increase of speculators in certain markets has resulted in heightened correlation between asset classes, for example, equities and commodities have been moving inline.... An active manager who can provide uncorrelated returns to diversify a portfolio and steady the return profile again is attractive

Differentiating. In contrast, correlations between investments within each asset class are falling. The FT recently reported that the correlation between stocks in the S&P 500 index has fallen to levels not seen since June 2007. This means there is a widening divergence between returns. Therefore, the ability to differentiate between opportunities within a subset is a strength of active over passive investing.

So what can you co?

Be strategic: Strategy choice matters so utilize your views on the macroeconomic environment to help determine which strategies in which to invest

Be sensible: Ensure funds deserve the fees they are charging, e.g. are focused on portfolio construction, generating returns from niche strategies, and structured appropriately with the redemption frequency matching the liquidity of the underlying investments.

Speak up: It is as important for BOTH sides to manage expectations to avoid redemptions from investors, and side pockets from funds.