You have all probably heard of hedge funds, but what exactly are they?
A hedge fund is a fund which can take both long (buy and hold) and short (selling shares without owning them) positions.
It can also buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it sees future impressive gains at reduced risk.
A frequently expressed view is that hedge funds are very risky and, although investors may earn significant returns, they are at high risk of losing a significant proportion of their capital.
Confusion can arise from the simple term “hedge” that implies the funds are simply running hedged positions, which is not always the case.
Hedge funds and the managers who run them have been getting a lot of publicity lately and not of the flattering kind. Their strategies vary enormously. There are about 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return.
The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.
A macro hedge fund, for example, invests in stock and bond markets and other investment opportunities, such as currencies, in hopes of profiting on significant shifts in such things as global interest rates and countries’ economic policies.
A macro hedge fund is more volatile but potentially faster growing than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress.
An equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or indices.
A relative-value hedge fund takes advantage of price or spread inefficiencies. Knowing and understanding the characteristics of the many different hedge-fund strategies is essential to capitalising on their variety of investment opportunities.
There are four key benefits of investing in hedge funds:
Diversification across multiple asset classes. Hedge funds operate in any and every asset class imaginable, from traditional equities and bonds to currencies, commodities, real estate, and even fine art.
Global diversification. While most of the strategies used by hedge-fund managers are concentrated in developed countries, there are funds focused on the emerging markets of Asia, Latin America, and eastern Europe. More recently, hedge funds are venturing into frontier markets, for example the extremely underdeveloped markets of Africa and the Middle East.
Non-correlation with traditional investments. Hedge funds can use futures, swaps, and options.
This allows them to produce returns that vary wildly from those of broad stock markets and other more common investments.
The concept of absolute returns. Hedge funds exist to make money in any market environment. They are not content to help you “lose less money than the averages”. They make their fees only if they give you a positive absolute return. This is a very powerful incentive. It is backed by years of solid performance.
For investors, hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets. Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing. Although not all hedge funds are high risk, some of the strategies used by some will be, and investors need to be sure they appreciate the level of risk.
So before you leap, you need to look carefully and deeply into this industry. When you do, however, you will also find that there’s a lot more to hedge funds. Hedge funds are increasingly becoming an integral part of the financial investment landscape. They often outperform the broad stock market by wide margins.
Many are designed to make money in any market environment and they are now more accessible via a fast-growing new vehicle (funds of hedge funds) or the recently launched exchange-traded fund. They are based offshore and are not regulated by the Financial Serv-ices Authority, so the warning to seek advice before buying applies with extra force.
William Wordie is with stockbroker Redmayne-Bentley and can be contacted on 01667 455577