Hedge Funds (HF)

Hedge Funds are actively managed liquid strategies spanning equity long/short, macro, relative value, event-driven, and systematic trading. Unlike private markets, hedge funds are evaluated not only on returns, but on how returns are generated, how risk is controlled, and how the strategy behaves when liquidity and correlations compress.

From an allocator perspective, Hedge Funds are not “one asset class.” They are a collection of return drivers that must be underwritten on repeatability and risk mechanics, not storytelling.

How allocators define Hedge Fund exposure

Allocators segment hedge fund exposure across:

• Primary return driver: discretionary vs systematic; carry vs trading
• Beta profile: net exposure, factor tilts, hidden market sensitivity
• Convexity: crash protection vs crash vulnerability
• Leverage & financing: prime brokerage reliance, margin sensitivity, repo terms
• Liquidity integrity: redemption terms vs underlying liquidity; gates/side pockets
• Crowding risk: consensus trades, factor overlap, unwind vulnerability
• Capacity limits: how asset growth impacts execution and opportunity set

A CIO is rarely asking: “Do we allocate to hedge funds?”
The framing question is: “Which strategies deliver defensible alpha with acceptable drawdowns and true liquidity?”

Core strategies within Hedge Funds

• Equity Long/Short: stock selection with controlled net exposure
• Macro (Discretionary/Systematic): rates, FX, commodities, index hedges
• Relative Value: spread trading and pricing inefficiencies (rates/credit)
• Event-Driven: catalysts (M&A, restructurings, corporate actions)
• Systematic/Quant: rules-based signals; execution and regime risk matter

How Hedge Funds fit into allocator portfolios

Allocators typically use hedge funds to achieve:

• Diversification beyond public equity beta
• Smoother return paths vs long-only mandates
• Potential crisis resilience (strategy-dependent)
• Liquidity balance against private market lockups
• Tactical risk shaping within policy constraints

How allocators evaluate Hedge Fund managers

Allocator conviction increases when a manager demonstrates:

• A specific, stable edge (data, process, execution)
• Transparent exposures (factors, hedges, risk limits)
• Consistent risk discipline in volatility spikes
• Evidence across regimes (not one favorable backdrop)
• Operational robustness (prime, controls, valuation, reporting)

Allocators are not optimizing for a Sharpe ratio in isolation.
They are underwriting drawdown mechanics and predictability of process.

What slows allocator decision-making

Hedge fund diligence stalls due to:

• Exposure opacity (“black box” positioning)
• Strategy drift as AUM grows
• Liquidity mismatch and gate/side-pocket risk
• Hidden leverage or fragile carry trades
• Crowded factor bets masked as “alpha”

Common misconceptions about Hedge Funds

• “Low volatility equals low risk” → low volatility can hide tail risk and liquidity fragility.
• “Quant means diversified” → many quant books share factor and crowding exposure.
• “Hedged means protected” → hedges fail when correlations converge and financing tightens.

Key allocator questions during diligence

• What is the repeatable alpha source—specifically?
• What are the explicit risk limits (net, gross, drawdown, factor)?
• What breaks first under stress: financing, liquidity, correlations, or execution?
• How does the strategy behave during 2008/2020/2022-like regimes (or proxies)?
• How liquid is the portfolio versus the fund terms?
• What is the plan if assets double (capacity discipline)?