What is a hedge fund?

11 July 2018
Put away the shears. A hedge fund is definitely not the latest gardening fad. It is instead a method of potentially delivering a healthier return to investors.

Hedge funds offer an investing alternative for the more sophisticated investor. They aim to create value through their managers’ skill and do not rely solely on market growth to make profits. They have the flexibility to use derivatives and arbitrage strategies and may offer performance potential and diversification benefits.

Hedge funds are similar to managed funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. The general objective of a hedge fund is to provide investors with positive returns in most market conditions.

Not for the novice investor, nor usually the low-net-worth individual, these specialized portfolios are the darlings of the investment world, attracting top managers, institutions, pensions and wealthy individuals to their fold. But as an alternative investment vehicles they are not without risk. Hedge funds are constantly balancing opportunity with risk and this is where the skill of the manager is paramount.

Portfolio managers typically take short positions in securities — bets on falling prices — as well as long positions that benefit from rising valuations. They also use borrowed cash — leverage — to magnify returns. The idea is to hedge against market declines (hence the name) and produce consistently positive returns, irrespective of the direction of the overall market.

There are many different types of hedge funds and the features and risks of each will depend on the fund’s strategy, the types of assets it invests in, where the assets are located, the investment tools used and the managers’ skill and knowledge.

The main allure of hedge funds is that, when done well, they contribute a return that isn’t closely tied to global stock and bond markets, providing diversity to an investor’s portfolio. If not done well though, they could magnify your losses.

Tools of the trade

Melbourne man Alfred Jones is credited as the ‘inventor’ of the hedge fund, starting the first in the United States in 1949. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an effort to enhance returns.

Since those days, hedge funds have diversified and there are now thousands of funds around the world offering an ever-increasing array of exotic strategies, including currency trading, high frequency trading and derivatives such as futures and options.

How do you invest in a hedge fund?

This area of investing was always reserved for the rich and in some cases in Australia still the minimum you’ll need is $50,000. However, today’s hedge funds have also expanded to encompass those with thousands of dollars, rather than millions, to spend. This gives the ordinary investor access to the expertise of skilled investment managers once reserved for the well-heeled.

Australia’s hedge funds are small in number and don’t have a lot of assets under management. According to a report published by ASIC in 2015, single-manager hedge funds, at $83.7 billion under management, represent only 3.5% of all Australian managed fund assets. There are 473 local hedge funds with about half of them managing just $50 million in investments.

If you’re considering investing in a hedge fund, it’s a wise move to do your research and seek professional advice first. As you know, choosing the investments that are right for you doesn’t just involve focusing on returns. There are other factors to consider, like the frequency of income and how that income is impacted by tax, and of course the level of underlying risk, as it pertains to your life stage and personal goals.

Risks to be aware of

Hedge funds, because of their diverse investment strategies, complex structures and use of leverage, short selling and derivatives can pose more complex risks for investors than traditional funds.  Investors need knowledge to assess factors such as how their money is to be invested, who makes key decisions for the fund, how the assets will be valued, and how investors can withdraw their money, as well as details relating to leveraging, derivatives and short selling.

As with any investment, you should understand exactly what you are investing in. You need to know what the fund’s strategy is and it has to make sense to you. Most hedge funds are created by fund managers who decide to start their own business and, because the skill of the managers is a key performance driver, you should understand the people involved.

The liquidity offered to you by the fund and the liquidity of the underlying investment should be consistent. There have been many problems caused by funds holding illiquid investments when large numbers of investors want to redeem units. You may have to accept that investments can only be redeemed with considerable notice or at particular intervals.

Joining this exclusive investing club can mean:

  • Membership has its price: Hedge fund investors must usually be wealthy already. There are hedge-like managed funds that give ordinary investors a shot. But the more accessible funds may offer more limited opportunity by having less flexible tools and strategies at their disposal.
  • Fees and taxes: Fees are hefty, typically 2% of assets plus 20% of profits. The trading patterns of hedge funds also expose you to larger tax bills. You need to understand how much of the performance is being eaten away in fees and whether you believe that the performance of your investment return is commensurate with the risks involved.
  • Leverage and short selling: These are great tools for funds but they also present greater potential risk. Leverage and short selling are crucial tools that can help hedge funds generate steady gains even if markets are falling. However, they also present potential risks that traditional managed funds don’t face. A short position can lose an unlimited amount of money as the security in question keeps rising. In contrast, a long position can fall no further than zero. Leverage, or borrowed money, can magnify gains, but can also exacerbate losses and force some managers to sell positions into weak markets. The ability to use leverage is important, but you also have to understand that it adds dramatically to the amount of risk you’re taking.
  • Lockups and lack of liquidity: Hedge fund investors often must commit their money for three months or more and managers have the right to limit withdrawals. Hedge funds don’t let investors withdraw their money daily like managed funds. In fact, most hedge funds have so-called lockups of at least three months. Some tie up clients’ money for as much as three years. “Gates” are also common. A gate limits the proportion of a fund’s capital that can be withdrawn by investors. If investors representing a big enough portion of a hedge fund’s assets clamour for their money, the gate comes down and all redemptions are frozen. Lockups and gates help hedge fund managers invest in less liquid assets and securities. But investors need to know that their money could be inaccessible for long periods. If you think you’re going to need the money for something within a short time, you probably shouldn’t be investing in hedge funds.

No one can say that one investment is better than the other. And past returns are no guide for the future. It is important to educate yourself as much as you can before adding a complex product such as a hedge fund to your investment portfolio.

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