Managing a Portfolio of Hedge Funds with First-Loss Scheme

Abstract

In the so-called first-loss scheme fee structure for hedge funds, investors offer more incentive fee than in the traditional scheme, in exchange for some protection of the first loss. The scheme gains more attentions in the recent years, given the current low interest rate environment and the generally lagging hedge fund performance. The flexibility of fee structure is also welcomed by hedge fund managers as a new way to attract more capital and broaden the investor base. In this article, the authors provide a quantitative framework to manage a portfolio of hedge funds with first-loss schemes. In the framework, the investor not only needs to determine to optimal allocation of capital amongst the hedge funds, but also the optimal choice of loss protections for the hedge funds. Using the solution provided by the framework, the authors also show that, with the capacity to select the suitable loss protection, a portfolio can be constructed to better match the investor’s risk-return profile than the one confined by the traditional scheme.