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What is a Hedge Fund??
What is a Hedge Fund?
Hedge Funds represent a $400-$500 billion industry, and one which is growing at an estimated 20% per year. There are now around 6,000 active hedge funds worldwide.
Hedge Funds are pooled investments for the purposes of trading securities. But, unlike conventional equity or mutual funds (unit trusts), they are far more flexible in the investment options open to them. So, for instance, if a Hedge Fund manager believes a certain stock to be over-valued, he can “borrow” these stocks and sell them in the hope of buying them back at a lower price.
In this way a manager “hedges his bets” in falling markets so as to make money in circumstances where conventional investments generally require a rise in stock value in order to profit.
Investing in hedge funds tends to be favored by more sophisticated investors, both institutions and individuals. These investors appreciate the benefits of absolute return investing, focused on capital preservation, not just out-performing an index.
The Rewards
Hedge Funds generally have substantially outperformed equities in recent years. An investor in standard mutual funds (MSCI World) in January 1990 would have expected to see a 150% return on their investment by January 2001. The same investor in Hedge Funds (HFRI Fund Weighted Composite) would have seen a return of 475%.
The very best funds have provided even better performance, as some of the most talented managers in any market have been drawn to Hedge Funds. They are attracted by the greater investment freedom that Hedge Funds offer, allowing them to take advantage of their market expertise to add value, irrespective of the direction in the bond and equity markets. The best also welcome the opportunity according to performance.
Many large institutions and high net worth individuals recognize that this freedom enjoyed by Hedge Fund managers leads to greater diversity of investment strategies, and to reduced volatility. The ability to diversify pure equity risk and the low correlation with other asset classes effectively reduces the risk level of a traditional portfolio.
The freedoms which allow the best Hedge Fund Managers to take advantage of any market movement are the same freedoms which allow poor managers to perform even worse. Consequently the range of returns from hedge fund managers – from the very best to the very worst – is much larger than for traditional equity or fixed income managers. Some funds, such as Long Term Capital Management, have so over-stretched themselves that they have failed.
Moreover, Hedge Funds are prohibited from advertising, which means there is little widely available information about a particular fund. They are also limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.
However, these risk factors can be addressed by using the “fund of funds” approach. A good fund of funds manager will use their expertise to construct a diversified portfolio of top quality managers, and continuously monitor them over time.
