514 ALTERNATIVE ASSET CLASSES MONITORING Hedge fund investing requires a commitment to monitoring hedge funds and the portfolio
of hedge funds. Monitoring involves both a quantitative and a qualitative approach. Returns data and other available data may be used to evaluate each hedge fund's return profile for consistency with the stated investment strategy. In addition, regular contact with the manager will foster dialogue and understanding of the manager's approach and adherence to that approach. Much of hedge fund monitoring is intended to detect style drift. Style drift occurs when the hedge fund's investments are inconsistent with its articulated strategy. This drift could take any one of a number of forms, including changes in the types of assets in the manager's universe or changes in the manager's portfolio construction rules or risk process. Although some changes may be welcomed, investors should be aware of shifts so that expectations and portfolio allocations can be adjusted accordingly. In some cases, style drift may justify termination of the manager. For investors who receive only fund net asset values, style drift may be detected by observing returns and noticing outsized positive or negative returns, or that the strategy does not exhibit expected correlations. If a greater degree of portfolio transparency is available, and if sufficient infrastructure and analytical tools are in place, analysis of portfolio positions is an excellent means of evaluating the hedge fund's adherence to the stated style. Organizational changes may adversely affect returns. Material changes in personnel, assets under management, or service providers are examples of organizational changes of which an investor will want to be aware. In addition to monitoring individual hedge funds, the portfolio of funds must be reviewed to assess whether it continues to meet its objectives, and to ensure that allocations to funds continue to appropriately balance expected return and contribution to risk. Changes in fund strategies or markets may alter correlations between funds as well as their expected returns and risk, changing the portfolio's risk/return profile. Consequently, monitoring will attempt to flag changes in expected return and risk for the portfolio of hedge funds. ONGOING PORTFOLIO MANAGEMENT After initiation, investors reevaluate their portfolios and may choose to reallocate capital. For the most part, this is simply a matter of continually running through the process of manager evaluation and portfolio construction. Regular decisions are made about increasing and decreasing allocations to managers and strategies, with the extremes being addition of new hedge funds or termination of existing managers. Reasons for terminating a manager include poor returns, organizational turmoil, and style drift. There is an important and unique consideration related to the performance fee and high-water mark, however, that arises in deciding to adjust hedge fund allocations. Suppose a Si million investment has been made in Hedge Fund A, but that this manager has lost 20 percent of the fund's assets since the investment was made. NAV is now $800,000. The hedge fund investor wants to replace Hedge Fund A with Hedge Fund B, which executes roughly the same strategy, but has performed
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