How can hedge funds set themselves apart in what has become a highly competitive and crowded marketplace?

Performance is the ultimate arbiter. Which is why many in the industry are embracing investment diversification in the search for new sources of risk-adjusted returns.

As a panel of industry experts and I discussed on the recent SS&C Advent-sponsored HFM webinar Beyond hedge funds – Diversifying into new asset classes, diversification takes more than an idea and the right investment expertise. High quality, often specialized risk, compliance and operational support are essential ingredients in diversifying with confidence.

Diversification drivers

As HFM Global associate analyst and webinar moderator Stuart Kinnaird pointed out, 70 of the world’s top 100 fund managers—a large percentage of the industry’s assets under management—have diversified beyond the traditional hedge fund space.

Why?

With more money flowing into the industry, trades have become increasingly crowded. Shifting into diverse, often esoteric asset classes and markets offers opportunities to enhance returns. Plus it’s a chance to demonstrate to today’s more sophisticated investors—with their portfolio metrics and tighter oversight—that you’re delivering value.

Capital flow trends are another reason. Diversification is often spurred by investor queries. A multi-strategy approach also broadens hedge funds’ appeal to a wider range of allocators, and gives managers the flexibility to pivot quickly to exploit often transient opportunities as they arise—a powerful advantage in volatile markets.

A further driver has been larger allocators’ push for more customized portfolios. That is motivating managers to come up with unique investment ideas outside their main portfolios, said Mike Fastert, Chief Operating Officer and Chief Legal Officer with NY-based hedge fund platform TIG Advisors.

Too much of a good thing?

Diversification comes at a price. Branching out into new asset classes and markets may offer performance opportunities, but only where managers have the skill and experience to deliver.

“When you start asking managers to diversify how they trade, that’s when the wheels can come off,” warned Darryl Noik, Chief Operating Officer and Chief Compliance Officer of London-based Capricorn Fund Managers.

Understanding and meeting associated risk and compliance obligations and delivering necessary transparency and reporting add further complication—and cost.

Navigating the diversification risks

Successful diversification then—to ensure you can actually handle the different asset classes and counter any investor concerns—demands a well thought-out plan that encompasses not only the investment strategy, but the legal, technology and operations ramifications. As Fastert observed, diversification efforts that fall down on reporting, and can’t provide investors with the transparency and insights they need, will fail.

Due diligence processes are where the red flags are often exposed, said Noik. “You may be able to get through the investment DD, but then you get onto risk and operational DD. If you don’t have these things in place, you’ll get found out very quickly.”

Infrastructure matters

Technology decisions will be crucial. The emphasis must be on future proofing the business—implementing the right platform that won’t cause mistakes, risk or rigidity going forward, as spreadsheets do. Without it, hedge funds will continue to face the same challenges every time they try to diversify into something new.

Solutions with comprehensive instrument coverage and full transparency, reporting and control capabilities baked in can provide that much-needed diversification flexibility and robustness. They also allow for greater speed of maneuver, enabling firms to respond faster to investor requests while minimizing front office frustration at the pace of action. Cloud-delivered software can help further by getting firms up and running faster and potentially bringing cost savings.

Those flexibility requirements go beyond supporting firms’ horizontal asset class diversification ambitions too. With hedge funds increasingly turning to closed-end funds and hybrid structures, systems need to be able to cope with vertical diversification into different markets and fund types (moves that can have a big after-tax impact on asset returns). Accommodating the look-through aspects of those structures to support investor accounting and reporting is vital.

Outsourcing support

The support tools don’t have to be limited to software systems. Augmenting technology with operational outsourcing can add valuable flexibility, control and cost efficiency.

It can help get strategies to market faster and more efficiently, serving as “training wheels” until the firm is up to speed. The internal operations team also gains some breathing room to concentrate on the most important activities at the outset—especially risk, compliance and providing value to investors.

However, outsourcing is no silver bullet. Thorough due diligence, choosing the right outsourcer with relevant experience and toolset, and staying on top of the provider to make sure they are properly managed is vital.

Adding value

What matters, concluded Fastert, is finding “your right mix of in-house personnel, systems automation and outsourcing that makes your team run the best, and adds the most value to your front office.”

Done right, diversification can then become a powerful source of value add for hedge funds.