Selecting the right product for your portfolio or to offer your clients is a challening task. And it gets no Easier once you start looking at hedge funds. But, what is a hedge fund?

There seems to be a general, universally accepted definition of what a hedge fund is.

A precise definition of the term hedge fund is difficult to provide as the industry by nature is constantly evolving. Trading techniques will be replaced and redefined constant and the number of sub-strategies is increasing steadily. The underlying philosophy of the hedge fund industry is that manager’s skill (alpha) rather than the development of a market or asset class (beta) largely define the success of a particular strategy.

While there is no universally accepted definition, there are some typical charectaristics to hedgefunds that differentiate them from traditional investments. Typically, they would not correlate or aim to correlate with equity and bond markets.

Another characteristic is that managers often are big investors in their own fund and that the funds prospectus and statutes allows to be more flexible in its management and have the ability to use different instruments in trading, more concentrated portfolios, long and short exposure and take opportunistic positions.

Hedge Fund mangers are often paid by a mix of a fixed management fee and a performance fee, depending on returns that can be generated for the investor.

Among the vast universe of hedgefunds, globally estimated to be more than 8000 vehicles to access, how does one find the right ones for the portfolio?

Seperating the good from the bad often fails with defining what is good and what is bad. One investor may want to achieve the highest possible return with a high risk tolerance, so a steady year on year return with very low volatility desired by another investor would be rather unapealing.

Performance charecteristics and expectations are of course only a small aspect to consider. There are many criteria which will influence the return in your investments and they also change over time. Administrative setup of the fund and managment firm, transparency and liquidity to name some are crucial, not just in the post-Madoff-area-invesotrs mindset, as are fees and the size of the fund and company.

But with these two examples, fees and assets under management (AuM) I want to highlight that the obvious may not always be in your best interest. With hedgefunds, it may be more crucial to see aspects in differentiated ways than with traditional investments and understand the methodology behind the trading approach and mechanics of the business of a fund manager.

AuM is one criteria not to underestimate. Is the fund big enough? Can the manager apply his trading strategy as he defined it, access all instruments, markets, brokers etc. that give him the best shot at generating the risk adjusted returns he set out to do? Some strategies are more critical to having enough money to trade than others of course. An equity trader will usually find it much easier to buy the exact number of shares he needs, say for 88.500 dollars. But think of managed futures trader who´s system tells him to do the same: The margin requirement for a futures contract may be 25.000 USD. Choices will have to be made to buy three or four contracts to allocate 88.500 USD, a difference of 33% in exposure leaving the manager- over underexposed from the calculated ideal.

So big is beautiful? Not always, again it very much depends on the approach. Many hedgefund styles are very sensitive to capacity limits or overcrowding. They simply can not trade the way with a billion Dollars as they did with 50 million Dollars because the markets they trade are too small or to tight. This may effect the entire trading concept or parts of it, like diversification within the portfolio.

The cost of being invested into a fund, the fees you pay are an important factor. Every little bit of fees saved goes to the advantage on your profit and loss acount, month for month and year for year. And not only since Albert Einsteins famous quote are we aware of the forces behind compound interest.

For many years, a 2+20 was international industry standard for hedge fund managers. (meaning, the manager receieves a fixed fee of 2% of the assets he manages and 20% oft he profits he can generate, usually above a hurdle rate). There has been huge pressure on the industry to reduce fees. But squeezing the manger out of the last drop of blood and cutting fees has a very serious downside.

A fund manager, usually, next to managing your assets has a business to run, salaries, rent and expenses to pay. It should be in your vital interest business goes well. The last thing you want is a manager or analyst pre-occupied and worried sick giving his every thought about paying the phone bill rather than improving his risk adjusted returns.

The managers earnings usually are usually closely tied to the assets he manages. A 100 million SEK manager in a difficult year on a 2+20 scheme therefor may have two million SEK pre tax to spend on research, IT equipement for better executions, travelling visiting companies speaking to CEOs and CFOs, pay for sound infrastructure such as custodians, legal and tax advisors, auditing and the costs that any other business has such as salaries, rent and some biscuits for the coffee table when you drop by to visit.

So, those having read this far will be dissapointed not to have found a checklist with boxes to tick off, filters to apply and ending up with a solid, unfailable guide to hedgefund investing. But here, at the end finally some advice: if you meet the guy that has that one-cures-all solution to add to your portfolio, run.