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January 27, 2006 2:24 pm

Hedge funds

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Hedge funds have been around since 1949. But they have only really started to capture the interest of private investors in the past 10 years and following the stock market crash in March 2000. Money tied up in these funds now stands at an estimated $1,200bn globally and that figure is still growing.

What exactly is a hedge fund?

The idea behind any hedging arrangement is to offset the potential loss on one trade against the profit on another, in an attempt to reduce risk. But there is no official or even widely accepted definition of a hedge fund and no two funds work in exactly the same way.

So how do they differ from conventional funds such as unit or investment trusts?

Quite a lot. Conventional funds are measured against a benchmark, usually either the performance of their own peer group or a particular index such as the FTSE 100. That means that if a fund falls by 20 per cent but its benchmark index has fallen by 25 per cent, then that fund is deemed to have outperformed.In contrast, hedge fund returns tend to be measured in absolute terms.

Any other differences?

Conventional funds move broadly in line with the markets so investors can expect to make money when markets are rising and lose money when markets are falling. In contrast, using the industry jargon,, hedge funds can go both “long” and “short” so in theory they can make money in all stock market environments. Going long involves buying a share or other asset in the hope that it will rise in value. This is what conventional investment funds do. Going short is selling securities which you do not own in the hope that they fall in value. Then you buy them back at a lower price and pocket the difference.

What’s the most common strategy used by hedge funds?

A relatively common strategy is “market neutral” where a manager may take a long position in one stock, say Tesco, and a short position on another, say Morrisons. The objective is to generate absolute returns while being largely uncorrelated with the equity markets. The skill lies in picking both winning and losing stocks.

“Equity long/short” is another popular strategy. It is similar to market/neutral, whereby hedge fund managers typically take both long and short positions, thereby stripping out much of the market risk. But a long bias can be introduced if the manager believes that the market will generally rise and alternatively a short bias can be introduced if the outlook is bearish.

But it is the “Global Macro” approach that most frequently grabs the headlines. This label covers a wide range of strategies with managers betting on anything from interest moves right through to swings in the oil price. Most famously, the financier George Soros made hundreds of millions of pounds betting against the pound when it was withdrawn from the Exchange Rate Mechanism in 1992.

What are the risks?

For private investors, they’re difficult to quantify.Many funds are exposed to three unusual risks. The first is “illiquidity” risk, which is the danger the hedge fund manager will have to sell illiquid assets at a big loss. The second is “tail” risk, which is the small probability of massive losses, associated with some options strategies. Finally, there is “phase-locking” risk, or the danger that previously uncorrelated assets can suddenly fall in tandem; this was what caused the high profile collapse of Long-Term Capital Management in 1998.

Are they easy to invest in?

Hedge funds have come more into the mainstream in terms of the breadth of companies offering them, withMany major retail houses, including New Star, Old Mutual and Gartmore, now run hedge funds. Some of the most recent launches include funds from Pinder Fry Benjamin and Close Man although there are at least 10 other retail funds chasing money. These include the Newton Phoenix Fund and two hedge funds from GAM.The other main route for private investors is through funds of hedge funds.

What are funds of hedge funds?

Funds of hedge funds normally invest in a range of different hedge funds giving investors access to a wide range of investment strategies.. The idea is that the manager of the fund of hedge funds will select suitable funds on the investor’s behalf, removing the nightmare of trying to find a top performing hedge fund manager. Although, of course you still have the problem of trying to find a decent fund of funds. They also have a lower investment threshold with minimum investments often around just $5,000. Even if you can get into some of the established hedge funds, minimum investments can run into millions of pounds.

What about charges?

If you thought conventional funds were expensive, you haven’t obviously haven’t had a looked at hedge fund charges. While a typical UK unit trust charges around 1.5 per cent of the value of the assets managed each year, a typical hedge fund charges 2 per cent annually plus an additional 20 per cent of all positive performance. Using simple maths, this equates to around $40bn paid out in hedge fund management and performance fees last year or about $4m in fees for every $100m managed. On funds of hedge funds expect to pay additional annual charges of
1 per cent and performance fees of 10 per cent.

Do performance related fees mean fund managers will be encouraged to take more risks to get higher returns? OP CUT??

Probably. Investors in hedge funds are looking for much better than average performance and are quite happy to accept higher risks in order to achieve that. It is also worth noting that it is not uncommon to hedge fund managers to have a very large stake in their own fund so they have a strong personal financial incentive not to get too over enthusiastic when maximising investment gains.

Do hedge funds work?

So far, the hedge fund managers appear to have been delivering. Only one hedge fund strategy – the dedicated short bias that works best in falling markets – has delivered a negative return over the last decade.

But returns are slowing. Figures from Hedge Fund Research (HFR) show that although 2003 was a good year for hedge funds globally, returning an average of 19.2 per cent, this figure fell to 8.9 per cent last year. This year HFR expects
the figure to be somewhere in between.

Part of the problem is that as the sector has boomed, it has brought many more people into the market, which some argue has lowered the quality of hedge fund managers.

This boom also means that more people are chasing the same limited arbitrage opportunities so it is getting even harder to make money. This has already occurred in some areas such as convertible bond arbitrage - where investors trade between shares and convertible bonds that eventually convert into shares. Many hedge funds that followed this strategy have had to look to new areas to make money.

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