Fuelled by the realisation that hedge funds can deliver attractive returns across most market condit...
Fuelled by the realisation that hedge funds can deliver attractive returns across most market conditions, their assets under management are growing rapidly. The first acknowledged hedge fund was launched in 1949. By the end of September 2002, $599bn was invested such vehicles.
Hedge funds have historically been the domain of the very wealthy but, recently, this situation has changed dramatically. The term 'hedge' is something of a misnomer. A better name is 'absolute return' funds. This reflects the intention of these managers to perform as well as they can under most market conditions rather than relative to a benchmark.
This approach does not mean that hedge fund managers generally take more market risk than a traditional manager. Indeed, when well executed they generally exhibit less market or directional risk, while assuming more credit risk than traditionally benchmarked strategies.
The absence of such a market benchmark against which risk is measured and taken means many hedge fund styles can position their portfolios in a neutral manner to preserve investor capital when market conditions require.
Traditional fund managers cannot do much to protect investors when markets turn down sharply. In the past three years, the fact the average hedge fund showed modest gains is testament to this. A traditional fund manager with a focus on outperforming a particular benchmark index cannot do much to protect their client assets when markets show sharp falls.
While hedge funds might not form the greater part of a portfolio, they do add distinct benefits, especially diversification and, where possible, should be considered by the majority of investors.
One way in which investment theory shows the benefits of diversification and how it can reduce the volatility of returns in a portfolio is the efficient frontier. The efficient frontier is a curve that describes the optimal combination of a portfolio of assets to achieve a given level of return, with the least amount of risk.
This curve shows that as more equities are added, volatility of returns decreases. The broad effect is a reduction in volatility combined with an attractive increase in returns.
The usual way to invest in the sector is through a portfolio of hedge funds spread across different strategies. This helps mitigate the risks of particular strategies and individual funds (so-called 'single manager risk').
Unfortunately, there are many funds to consider with meaningful differences in risk and return between them. Most hedge funds offer infrequent liquidity and many have a very high investment minimum ' $5m is not unusual.
For most individuals, structuring a sensible absolute return fund portfolio is difficult, requires substantial capital and is not achievable. Consequently, many turn to funds of hedge funds to access this sector in a controlled manner. The generally stated aim of many hedge fund portfolios is equity-like returns with lower levels of volatility than equities generally. They have typically shown good performance in positive markets, generally flat performance in bear markets and volatility dampening, especially in very volatile markets.
Jamie Murray, business development manager at HSBC Republic
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