Hedge funds

Hedge funds are difficult to define, because they are not a homogeneous group, despite this being the common perception. Hedge fund managers use many different approaches to managing money. As a result, hedge funds do not fit one definition.

It is possible, however, to highlight certain characteristics, some of which are used by all, or at least by many hedge funds. For example, generally hedge funds seek to generate absolute returns, rather than try to outperform an index. Hedge funds typically do not worry about whether the weightings of underlying holdings are close to those of an index.

Most hedge fund managers use short positions. Selling short is where a manager sells an asset he does not own, hoping to be able to buy it back again at a lower price. This done through borrowing shares. A hedge fund may use short selling to balance long positions it holds and therefore reduce risk in a portfolio. Of course, the fund will also short sell when the manager believes share prices will fall in the future.

While not true for all hedge funds, some can enhance returns and reduce volatility. Some strategies have a low correlation to equities and bonds. This can be achieved through the ability to short stocks and to take long positions, to have significant holdings in cash and the fund's investment flexibility. Hedge funds usually have few restrictions on their investment approach. This includes being able to borrow money, which is known as gearing, to enhance certain exposures and attempt to increase returns.

Hedge funds can also act as a diversifier, by providing low correlation to the traditional asset classes of equities and bonds, while funds of hedge funds diversify risk across a broad spectrum of hedge fund strategies.  Funds of hedge funds are the typical route for all but the wealthiest private investors, due to the diversification they can deliver.

Management incentives

Hedge fund managers traditionally invest in their own funds and may even own the business. This provides an incentive to both deliver positive returns and to protect capital. Another incentive can come through the application of performance fees, which are commonplace among hedge funds. In theory, they provide an incentive for managers to deliver absolute or positive returns and thus benefit from a higher fee. This should align the interests of hedge fund managers with investors as a positive return benefits both parties.

However, the use of performance fees can be a double-edged sword, in that there are potential disadvantages too. Hedge funds usually earn a fee of 10 percent to 20 percent of the out-performance of the fund, occasionally even more. This should be subject to what is known as a high water mark, to prevent you having to pay twice for the same gain. Under this system, when a fund falls in value, investors do not pay a performance fee again, until the price recovers to above the level where a performance fee was last charged. Many have hurdle rates, so that merely posting positive returns is not sufficient to earn a performance fee. The problem is that, more often than not, the positive return may be more the result of the market environment than the skill of the manager.

While performance fees should provide an extra incentive to hedge fund managers, it can also encourage more reckless management, as the manager tries to attain the performance fee as the year end approaches. It can lead to successful hedge fund managers accumulating enormous wealth, so losing their internal drive to deliver outperformance.

Another development in the hedge fund world, which has now spread to unit trusts, has been the limiting of the size of funds. It is argued that limiting the volume of assets provides more opportunities for hedge fund managers to out-perform, as they only need to invest in their best ideas. Too much money can lead to a dilution of the quality of a portfolio.

Factors that have restrained the growth of hedge funds among the wider investment public have included the requirements for high initial investments, the fact that they are usually subject to lighter regulatory controls than onshore unit trusts and the restricted size of hedge funds.

Different hedge fund strategies

As we said earlier, there are many different hedge fund strategies. Perhaps the most common strategy is equity long/short. A manager will take long positions in equities where he expects the share price to rise and go short where he expects the price to fall.

In merger arbitrage, managers tend to take long positions in companies subject to a takeover bid and short the shares of the bidding company. The major risk is if the deal fails to be completed.

Distressed securities managers buy shares in bankrupt companies, where they are at a discount to the company's intrinsic value. They may become involved in helping to restructure the company.

Global macro is one of the best known strategies, because of the activities of managers like George Soros. They take directional positions, in any asset class, in any region, on the basis of top-down macro views of the global economy.

Market neutral funds try to neutralise market risk, by simultaneously taking long and short positions. Some managers match long and short positions by sector, market cap or other criteria. This can enhance returns by selecting out-performing stocks, while minimising market risk. Ideally, a manager will take a long position in a stock that rises in value and short a stock that falls in value, where the overall market direction is difficult to predict. While the volatility of stock market returns can be reduced, the opportunity for out-performance is limited.

As a result of the different strategies and investment flexibility, it is impossible to generalise about the risk return characteristics of hedge funds.

This is not to deny that hedge funds can pose relatively high risks, such as through the use of gearing. You need to carry out due diligence, because of the often lower levels of transparency and regulation, compared to the mainstream investment industry.

Some hedge funds close, because the manager has failed to raise sufficient capital to make it cost-effective to continue, rather than because of poor performance. In these cases, the initial capital is returned to investors along with any profits.

This last point raises questions about how much importance you should place on hedge fund indices. This is because of survivor bias, in which wound up funds are not included within indices. This can provide an upward bias to index performance.

A key risk of investing in hedge funds is liquidity, or in some cases the lack of it. Many hedge funds and some fund of hedge funds only allow you to redeem capital every month, or even every three months.

Despite these concerns, hedge funds can play an important role in your investment portfolios. This is because of their attractions as a risk diversifier, because they can have low correlations to other asset classes. Generally, they have greater investment flexibility than mainstream funds and can exploit inefficiencies wherever they find them. However, because many hedge funds use gearing to take short positions, you really need to understand what you are buying and the levels of leverage risk you are taking.