The start of the year 2001 has seen equity prices continue to fall. One, but by no means the only, e...
The start of the year 2001 has seen equity prices continue to fall. One, but by no means the only, example of this is the FTSE 100, which closed at 5,314.80 on 22 March 2001, a fall of more than 20% from its peak closing value of 6,930.20 on 30 December 1999. This kind of dramatic reduction has led many investors, and their advisers, to consider different opportunities to conventional equity and bond investments. One such opportunity is an investment in hedge funds.
Basically, hedge funds can invest in different asset classes such as equities, bonds, currencies and derivatives. However, as individual hedge funds are not regulated, they have more flexibility to exploit opportunities than conventional regulated funds.
Perhaps the most well known example of this is short-selling.
If conventional equity fund managers feel that a particular stock is overvalued, the most positive action they can take is not to hold the stock. In contrast, a hedge fund manager can sell the stock short, hoping to buy it back at a lower price than they paid for it.
The mechanics of this are that the hedge fund manager borrows the stock from a broker and then sells it on. When the stock falls to the required level, the profit made is the difference between the buying and selling prices, less the fees paid to the broker.
Short selling demonstrates one of the main characterisations of hedge funds, namely the opportunity to produce positive returns in generally falling markets. This leads on to another characteristic, that of pursuing absolute returns rather than seeking to outperform a benchmark. In addition, hedge funds use other non-traditional strategies to get their returns, such as leverage and arbitrage opportunities.
Individual hedge funds are just that, with almost as many strategies as there are managers. Nevertheless, three of the better-known strategies are Global Macro, Arbitrage and Event-Driven. As the name suggests, Global Macro funds look at the whole world and take positions in particular markets or currencies. The most famous example of this was the George Soros fund, which made huge profits when Britain left the ERM in 1992.
Arbitrage strategies aim to profit from perceived marketing inefficiencies. For example, Convertible Bond Arbitrage managers will buy convertible bonds and sell the underlying equities in the belief that the convertible bonds will rise in value.
Takeovers are a good example of Event Driven strategies. Say company X announces a takeover of company Y and a hedge fund manager believes that the price is too high. In that case, they will sell company X's shares and buy company Y's shares. Profit would then arise from company X's shares falling due to the cost of the takeover and company Y's shares rising to the agreed purchase price.
As can be seen, hedge funds can use very different strategies to conventional equity and bond managers. This gives rise to one of their main attractions diversification. Hedge funds have a very low correlation to equities and bonds, which is extremely important in today's economic climate where most equity markets tend to follow the US to a greater or lesser extent. Hedge funds also offer the opportunity, though clearly not the guarantee, of high absolute returns.
Nevertheless, until recently, hedge funds have not been seen as investment opportunities for private investors. Some of the reasons for this have been their high minimum investments, the potentially high risks of individual hedge funds and their lack of regulation.
Recently however, several launches of retail-targeted funds of hedge funds have brought these opportunities to the retail investor for the first time. In fact, these offerings have been targeted to ensure their inclusion as Isa investments.
Funds of hedge funds typically offer investment in 20 to 30 hedge funds, ranging across many different hedge fund strategies. It was previously mentioned that individual hedge funds have a low correlation to traditional asset classes. In addition to this, there is also a low correlation between different hedge fund strategies. As a very simplistic example, a bond hedge fund strategy would have low correlation to an equity strategy since when equities rise, bonds tend to fall, and vice versa.
Therefore, by selecting several hedge funds with different strategies, it is possible to create a diversified fund of hedge funds with attractive potential returns. Only the very richest private individuals would be able to construct a suitably diversified portfolio from investment in individual hedge funds.
It is also possible, with a fund of hedge funds, to construct an investment with low volatility (risk) compared to other potentially high return assets. The graph details the gross returns per annum and the volatility of these returns for the CSFB Tremont Hedge Fund Index the hedge fund market benchmark reference index against some major equity indices as well as the JP Morgan Global Bond Index.
In fact, a suitably constructed fund of hedge funds would tend to have even lower volatility than the index.
The other main attraction of most of the recent funds of hedge funds launched is that they are regulated investments and so are available to Isa investors as well as for direct investment by UK taxpayers.
It has been shown above that it is possible to construct a low risk but potentially high return fund of hedge funds. Nevertheless, it is undoubtedly the case that hedge funds are a new asset class to Isa-type investors. Some providers have therefore launched products that also offer a minimum return to the investor at the end of the term of the investment of the amount actually invested. Even though inflation will have eroded the minimum return, this is still an important safeguard to many investors.
The method of providing protection is a more dynamic process than that under a conventional 'guaranteed' or 'protected' equity structure. It allows up to 100% of the investment to be invested into the fund of hedge funds at the outset and the cost of this protection is fairly modest, usually about 1% per annum.
Worldwide hedge fund investment has grown from under $50bn in 1990 to more than $450bn in 2000. Most hedge fund investment is still by institutions but funds of hedge funds are now becoming available to private investors using the same techniques, and in some cases, the same institutional funds. Protected hedge funds that offer a minimum return of the sum invested are an attractive way to introduce this relatively unfamiliar asset class to more typical retail investors.
Antony Stack is managing director of NDF Administration
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