By GRAHAM FROST 16/02/2007
Hedge funds are big business. Although they have yet to filter down to the man in the street (at least in their purest form), institutional investors such as pension funds and insurance companies appear to be lapping them up. The Bank of New York predicts that global institutional demand for hedge funds will soar from $360 billion to over $1 trillion by 2010 and high profile launches continue to proliferate. The Goldman Sachs Dynamic Opportunities fund of hedge funds raised $500m last year and Brevan Howard is aiming to raise £1 billion via its forthcoming BH Macro launch.
Are hedge funds really the hottest thing since sliced bread or are they simply a bubble waiting to burst? And should you be holding this style of investment in your portfolio?
| "Most hedge funds have a very simple objective: deliver absolute returns." |
Let’s start by explaining the genre. While hedge funds come in many shapes and sizes, the majority have a very simple objective: deliver positive returns irrespective of market movements (i.e. absolute returns). On this basis, cash is a good hedge. However, its long term return prospects are too dull to attract investors, so hedge fund managers strive to deliver attractive long term returns without the volatility associated with traditional stockmarket investing. They typically use a variety of sophisticated techniques to try and achieve this (more details here), but one of the more popular is a ‘long/short’ strategy. In simple terms this means they can benefit from both rising and falling markets, in theory producing consistent returns even if markets fall.
Do these techniques work? In very general terms it seems that they do. The graph below suggests that hedge funds (as measured by the CSFB Tremont Index) weathered the 2000-03 stockmarket down turn pretty well. However, this conclusion should be treated with much caution, as the headline Index figure naturally hides some of the failures. Furthermore, many of the better established hedge funds included in this Index have now closed to new business and the managers behind some newer entrants have yet to experience falling markets (when they will sink or swim).
For private investors there are currently two practical ways to buy into hedge style investments: funds of hedge funds listed on the London Stock Exchange and long/short UCITS III funds (unit trusts that permit the manager to benefit from falling markets). The former are investment companies that invest in a range of individual hedge funds. This is a sensible approach as holding a range of funds spreads risk and a good manager can pick the diamonds from the rough. On the downside they suffer from high charges and potential discount to net asset value volatility (as per investment trusts). The UCITS III route is more investor friendly and usually less expensive, but there are currently few equity long/short funds to choose from. There is a greater choice of ‘target return’ funds, which primarily invest in fixed interest, but these have largely failed to hit targets to date and remain unconvincing.
| "Amidst hedge fund fever it’s important to remember that a well-diversified portfolio is a good hedge in itself." |
Amidst hedge fund fever it’s important to remember that a well-diversified portfolio is a good hedge in itself. Holding a variety of assets that rarely all move in the same direction at the same time (e.g. equities, fixed interest, commodities and property) can go a long way towards delivering consistent returns – this forms the basis for our suggested model portfolios. Hedge funds can play a potentially valuable role within this, but they are not essential and should not be viewed as a one-stop shop investment solution.
To conclude, we believe hedge funds are a worthwhile investment type and not a passing fad. There will undoubtedly be failures, so making the right choice is vital and holding several prudent. In practice the options for private investors are still limited, but expect this to change when the FSA permits hedge funds to be marketed to UK investors and more providers launch funds for the retail market. In any case, specialist advice is essential.