Hedge funds, once considered the select investment vehicles of the ultra-high net worth and large family offices, have evolved to become a standard core holding for institutional investors and a broader range of private investors globally.

They differ from traditional investments, such as unit trusts, in two primary ways:

• Firstly, a hedge fund manager has the flexibility to invest in a wide range of asset classes and can employ investment techniques not available to traditional investment funds. These techniques may include ‘short selling’ stocks (in which profits are made when stocks decline in value); leverage or gearing (borrowing money to make additional investments); and the use of derivatives. Such strategies contribute to the risk involved in hedge fund investing.

• Secondly, while a traditional fund generally measures its performance relative to an equity benchmark (such as the FTSE 100), a hedge fund seeks to deliver returns under all market conditions, regardless of how the equity and bond markets perform. This is known as delivering ‘absolute returns’. Hedge fund managers can therefore be effective in helping to preserve capital in periods of market downturn.

Volatility

Hedge funds typically exhibit lower volatility and higher risk-adjusted returns than traditional asset classes. In other words, absolute returns generated by these strategies have been achieved with less volatility or risk than traditional equity investments.
Additionally, because their performance does not generally follow traditional equity indices, the majority of hedge fund returns have historically had low correlation to traditional investment returns. This means that while hedge funds may not be considered appropriate for the entirety of a portfolio, some degree of diversification can be expected from including these vehicles in your portfolio, and they may, therefore, improve the overall risk-adjusted return.

Fees and charges

Just as unit trusts charge fees for the management of their products in the form of, ‘front-end’ (entry) or ‘back-end’ (exit) fees, so, too, do hedge funds. These are typically composed of two parts: a management fee calculated on the total size of the investment, and a performance fee based on the success of the manager. A typical hedge fund fee is ‘two and 20’, which is a two per cent management fee and a 20 per cent performance fee. Note that the performance fee is normally only awarded if the fund’s returns surpass a certain level.

Risk and diversification

As with any investment, hedge funds pose potential risks. It is important to remember that there are many different hedge fund strategies that perform differently under various market conditions. There can also be significant differences among their risk and return characteristics.

Perhaps the most effective solution to these risks lies in diversification. Analysis indicates that, just as diversifying equity portfolios through investing in an array of stocks reduces the risks involved with investing in traditional equity markets, one can reduce the risk in hedge fund portfolios by investing through more than one manager.

Minimum investment

However, unlike that of stocks, the minimum investment in hedge funds can often be millions of dollars. An investor with limited assets to allocate to hedge funds needs a vehicle that accepts lower sums. It can also be a daunting task to select the specific strategies to invest in and then find hedge funds that operate these strategies successfully.

As an answer to these needs, the industry has developed ‘fund of hedge funds’ – pooled vehicles similar to unit trusts that provide investors with access to a group of hedge funds. It also transfers the onus of underlying hedge fund research from you to a team of skilled and experienced professional investors.

Regulation

Because of the known risks of investing in individual hedge funds, financial regulatory bodies worldwide have taken, or are in the process of taking, regulatory steps with the aim of protecting investors. It is hoped that this regulation will make the industry clearer and safer for investors while not compromising managers’ ability to produce high risk-adjusted returns.

UK retail investors can currently invest in funds of hedge funds that are listed on a stock exchange by purchasing shares as they would for any other company. The Financial Services Authority (FSA) proposes to make these products more widely available to retail investors so that they can be purchased directly from the fund manger like a unit trust or OEIC. Part of this change in regulation will involve ensuring that product providers conduct high levels of research and monitoring of the funds in which they invest.