With confidence in stock markets falling, investors have to be much more aware of risk, and with a favourable risk/return profile, hedge funds have grown in popularity with sophisticated investors
The British infatuation with equities is over. Its demise has been caused by three main factors: a market that has fallen by 37% from its peak and knocked the confidence of even the most optimistic of investors, record levels of equity volatility and historically low levels of inflation.
Clients, especially those nearing or in retirement, have been bruised by the fall in the value of their investment portfolio, which has been far more exposed to equities than the portfolios of clients on the Continent.
It is unrealistic to think that older clients will make up all the money they have lost by staying in equities and waiting for the bounce back because, with inflation at 2.1%, clients will have to take on a huge amount of risk to generate returns of that size.
Suddenly, the word risk has taken on a new meaning. When all asset classes seemed to be going up, it was difficult to get anyone to focus on the risks they were taking with their money. Now an appreciation of risk and how much of it you have to take to get a return is of paramount importance.
The starting point for clients when evaluating their portfolio is the risk-free rate of return represented by cash. If you put your money in a 60-day deposit account with Barclays, for example, you will get a net return of 2.24%. This is safe but it is lower than the consensus forecast of inflation for 2003 at 2.7%. Most clients will want to make sure that their investments are earning returns higher than inflation and are prepared to take on extra risk to achieve this.
Next up the risk scale is a gilt, yielding approximately 4%, also fairly safe as the Government is unlikely to default. Beyond this are managed gilt funds, then investment grade corporate bond funds and then high yielding, non- investment grade corporate bond funds.
As the potential returns (yields) rise, so does the potential risk of default of these fixed income providers and, therefore, the risk to both capital and income.
Next in the risk/return scale are funds of hedge funds. This is a new asset class to most UK financial advisers but has been used by US, UK and Continental high net worth clients for many years.
In terms of risk as measured by standard deviation, many funds of hedge funds are in a similar risk category to gilts as far as protection of capital is concerned but can provide returns that are considerably higher than fixed income investments such as gilts and bonds.
This favourable risk/return profile is why hedge funds have been so popular among sophisticated investors, many of whom share the same risk tolerances as the older clients nearing or in retirement in the UK today.
Their overriding aim is protection of capital but, at the same time, they want to expose their money to an asset class that has the potential to give them higher returns than cash, gilts and bonds and, most importantly, inflation.
Finally, in the risk/return spectrum come equities.
Clients owning equities either directly or in managed funds are exposing themselves to significant risk in order to give themselves the opportunity of returns which are significantly higher than inflation.
This level of risk taking worked well for most clients when inflation was at much higher levels and equities comfortably outpaced inflation ' cash and bonds generating annualised returns of 15% a year before income during the 1990s.
However, many clients forgot they were actually exposing themselves to risk until things started to go wrong.
Today, with inflation at 2.1%, clients wanting to generate 15% a year will need to take on much higher levels of risk than they are used to and it is likely only those with a lot of time ahead of them will want to exposure a high percentage of their portfolio to this level of risk.
What the market falls have shown financial advisers and their clients is that limiting risk is now a much more important part of financial planning.
Or put another way, most planners now put more emphasis on investments that have a high probability of generating positive returns.
UK financial advisers have long experience of equities and of bond investing but not of hedge funds.
However, hedge funds and especially funds of hedge funds are likely to become a much more important part of portfolio planning in this new risk conscious, positive return orientated environment.
The majority of hedge fund strategies have a lower risk profile than a straight equity investment and several have a risk profile similar to or lower than gilts and bonds. In response to the greater awareness of risk, there are an increasing number of funds of hedge funds being offered to UK financial advisers designed especially for their UK-domiciled clients.
Funds of funds that include a range of managers who specialise in arbitrage strategies are likely to be one of the lowest risk funds of hedge funds and these funds will normally aim to give investors annualised returns slightly above bonds.
Other funds of funds may include a wider range of strategies such as long/short equity and global macro and will have a higher risk of down months but should also be able to provide higher levels of positive returns than pure arbitrage funds.
There are some funds of hedge funds that only include a single strategy such as a fund of only long/short equity funds.
These funds could have larger losses in months that are negative than funds spread over a range of strategies but, conversely, they can generate larger positive numbers on the upside.
However, it is likely that a fund of long/short hedge funds will be less volatile and should provide better capital protection than a fund of pure equity funds.
For more information on hedge funds, the Matrix Guide to Hedge Funds is available by contacting Matrix on 020 7292 0825.
Bridget Cleverly is managing director at Matrix Money Management
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