To some observers, portfolio allocations to alternative investments should be modest, perhaps in the area of 5% to 10% or maybe slightly more.

That’s not the case with Scott Schweighauser, president of Chicago-based Aurora Investment, which manages hedge fund portfolios and is an affiliate of Natixis Global Asset Management. “Funds of hedge funds should be a core allocation for investors,” Schweighauser says, “and the bigger the better. That allocation should be at least 20% of the portfolio, I believe."

Why does Schweighauser believe they should play such a major role in clients’ portfolios? “Hedge fund strategies are unconstrained,” he says. “Generally, they don’t hew to a benchmark and they often have the ability to go long and short. They have a broad opportunity set, to seek equity-like returns, while their long-short nature can reduce volatility substantially. Historically, a diversified group of hedge funds has had an excellent Sharpe ratio of returns to risk.”

But to some, the lack of a benchmark isn't necessarily a positive feature. Determining an appropriate benchmark is a key step in understanding whether or not an investment makes sense in clients' portfolios, according to CFP Allan Roth, a Financial Planning contributing writer and the founder of planning firm Wealth Logic in Colorado Springs, Colo.

LOWER HURDLE

By going into a fund of hedge funds, which wrap a number of hedge fund strategies from multiple managers, investors clear a lower hurdle. They can obtain a mix of hedge fund strategies they otherwise would not be able to obtain because of the steep minimum investment requirement for many individual hedge funds.

“A qualified purchaser,” says Schweighauser, “can get into a fund of hedge funds for a minimum investment of $250,000.” For individuals, the Federal Investment Company Act defines qualified purchasers as those with at least $5 million of investments.

Recently, the spread of so-called liquid alts has brought funds of hedge funds to the broad class of investors. “In the past few years,” says Scott Schweighauser, “we have seen a tremendous increase in the number of talented hedge fund managers who are willing to be included in funds of hedge funds available to the general public.” Thus, funds of hedge funds in mutual fund form may offer several managers who typically had been accessible only to multimillionaires.

EXTRA FEES

Any type of fund-of-funds imposes an extra layer of fees, a feature about which the SEC and FINRA have both warned investors. But Schweighauser insists that those sponsor fees can be justified.

“We actively manage our funds of hedge funds,” he says, “adding managers who have excellent records while cutting back capital for those managers who haven’t performed well recently. Our annual manager turnover is in the 15%-20% range.” Professionally vetting managers and continually monitoring their performance are among the values a sponsor can add, Schweighauser contends.

Advisors interested in a fund of hedge funds should look at the continuity and experience of the sponsor’s management team, Schweighauser suggests. In addition, it may be helpful to evaluate how active a role a sponsor plays in determining the mix of strategies.

“In early 2014,” Schweighauser recalls, “we decided that the implementation of the Fed’s tapering [less expansive monetary policy] was going well. Therefore, we increased long-short equity and event-driven strategies in our funds of hedge funds, expecting to see more mergers, spinoffs, buybacks, and so on.”

Advisors looking at funds of hedge funds may want to investigate how much the sponsor engages in such efforts, and how well they have paid off in the past.

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

Donald Jay Korn

Donald Jay Korn is a New York-based financial writer who contributes to Financial Planning and On Wall Street.