Hedge funds are alternative investment vehicles that explicitly pursue absolute returns on their underlying investments. The term “hedge fund” has come to incorporate any absolute return fund investing within the financial markets (stocks, bonds, commodities, currencies, derivatives, etc) and/or applying non-traditional portfolio management techniques including, but not restricted to, short selling, leveraging, arbitrage, swaps, etc.

Initially devised in the US in 1949, hedge funds really took off in the late eighties, and now form a key part of both institutional and private client portfolios. They are normally used in a portfolio context rather than being considered as stand-alone investments.

Hedge funds are usually included as a medium to long-term investment in a traditional portfolio of stocks and bonds. As the performance of hedge funds in general tend to be lowly correlated to traditional investments – especially in declining markets when correlations tend to be low – they offer a good source of diversification for most investment portfolios. By blending a variety of skill-based approaches to investing in a diverse range of financial instruments and markets, hedge fund portfolio construction process aims to achieve a specific return/risk profile, as well as proper diversification and balance in the overall portfolio.

Traditional versus hedge fund investments

One of the main differences between traditional and hedge fund investments is that, for hedge funds, it is the skill of the manager (‘alpha’) rather than the performance of a market or an asset class (‘beta’) that drives returns.

Traditional asset managers generally allocate capital on a ‘long-only’ basis to stocks, bonds and cash. Portfolios are managed against a passive benchmark which they aim to outperform. The relative weighting of positions tend to have little deviation from the benchmark itself, resulting in very similar return profiles. Consequently, this makes it difficult for traditional managers to make money when markets are falling.

In a financial context, the term ‘hedge’ can be defined as ‘guarding against risk of loss’. As such, any inference that hedge funds are riskier than traditional investment strategies may be misguided, especially considering that the long-only approach has fewer options to protect itself from the fundamental risk of market downturns.

The underlying philosophy of the hedge fund industry is that, the skill of the manager (‘alpha’), rather than the performance of a market or asset class (‘beta’), should principally determine the success of the strategy. This key difference is also reflected in the performance-related remuneration of managers and the freedom that they are given to invest in a much broader range of financial instruments and assets.

Hedge fund managers employ a diverse and constantly evolving range of trading strategies to generate returns. Therefore, hedge funds can provide opportunities to manage risk as well as diversify in both bull and bear markets.

 

Traditional investments Hedge funds
Restricted opportunity set Can exploit wide range of price distortions
Mainly dependent on beta Focused on alpha generation
Relative return objectives Target consistent performance
Flat fee structure Alignment of manager/investor interests
Limited diversification sources Large number of strategies
Inefficient dispersion of risk Enhanced risk/reward trade-off

 

Benefits and Risks:

Benefits:

Performance consistency

Managers are typically unrestricted in their choice of investment strategies and have the ability to invest in any asset class or instrument. As such, managers target consistent, absolute returns rather than outperformance of a benchmark.

Low correlation

By utilising a range of investment strategies/financial instruments, and by being able to profit in both rising and falling market conditions, hedge funds have the ability to generate returns that have little correlation to traditional investments.

Downside limitation

Hedge funds seek to limit against, and potentially profit from, declining markets by utilising various hedging strategies.

Hedge funds may be well positioned to deal with falling markets because they:

  • capitalise on declining market prices (through short selling)
  • use dynamic trading strategies
  • benefit from greater diversification and active asset allocation

Risks

When considering alternative investments, including hedge funds, investors should consider various risks including

  • Loss of investment
  • Liquidity issues
  • Use of leverage
  • Speculative investment practices
  • Difficulty valuing certain assets
  • Higher fees
  • Limited regulatory protections

Hedge Fund Styles:

There are five main hedge fund styles representing a wide range of risk/return characteristics, each of which has a number of sub-strategies.

Equity Hedge Funds:

Profits from taking up long and offsetting short positions in undervalued and overvalued stocks with a fixed or variable underlying net long or short exposure.

Managed Futures:

Global trading in futures and derivatives on financial instruments and goods (systematic, long-term trend-following models, discretionary strategies and short-term, active trading strategies)

Event Driven:

Buying and short selling of securities of companies experiencing or involved in substantial corporate changes (merger, arbitrage, distressed securities and special situations)

Global Macro:

Analysis of shifts in macroeconomic trends to capitalize on upward and downward directional opportunities across various markets, asset classes and financial instruments.

Relative Value:

Exploitation of mispricing and changing price relationships between related securities (convertible bond arbitrage, fixed income arbitrage, statistical arbitrage)

As with any investment, hedge funds can lose money as well as profit. Investors should always seek professional advice before considering any investment.

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