Losing a bit of mystique

Accessible and transparent, hedge funds are becoming suitable for a wider range of investors.

Fund manager Alfred Jones developed the first hedge fund in 1949. His concept has grown into an industry worth around E400bn, with over 6000 funds active in 2003. Traditional mystique is giving way to increasing transparency, particularly with more institutions entering the marketplace. Once the preserve of the mega-rich, hedge funds are becoming more accessible to mid-range investors. Classified as “alternative” investments, hedge funds aim to perform differently to traditional investment vehicles. They provide diversification in broad portfolios and enhance the risk-adjusted returns, often through the use of hedging. With greater choice available to investors, an understanding of the main strategies is the key to making the correct choice of fund for a portfolio. All hedge fund strategies are based around the same assets that are available on the long side, such as equities, bonds and property. The main difference with hedge funds is that the underlying assets can be bought and sold. They can also employ leverage or gearing, and therefore have greater flexibility. Hedge funds are available as “single strategy” funds or as “fund of funds”. It is important to note that in most countries single strategy hedge funds are not available to retail customers. Most managers of single strategy hedge funds are specialists. For example, where one manager specialises in macro, another will offer expertise in fixed income. There are around 14 strategies but four dominate the market for single strategy funds. The largest category is “equity long/short”. Long simply means buying, short simply means selling. The manager can generate returns when shares go down as well as up, which has been beneficial over the last three years. Equity hedge funds tend to use less leverage than fixed income funds. Equities are inherently riskier than bonds as they are more volatile. Fixed income strategies are based on fixed income instruments such as government or convertible bonds. The focus is on yield rather than solely on capital gain. Managers may use leverage to buy bonds or fixed income derivatives to profit from principal appreciation. With “event-driven” strategies such as convertible arbitrage and merger and acquisition strategies, managers attempt to take advantage of specific events. For example, when one company bids for another, the manager can take a view on the outcome of the bid. Typically the share prices will move – one up and the other down. The fourth category is known as “macro”, where managers are attempting to anticipate key trends, for example in currencies, interest rates or the price of oil. So they have a broad remit. Most equity hedge funds are at the high end of risk/return strategies. Typically such funds will seek returns of around 15 per cent a year. Fixed income funds are at the low end, typically six to eight per cent. Event-driven and macro funds fall somewhere between the two. In each case the manager is attempting to deliver a lower element of risk and volatility than is inherent in the underlying assets. So a typical equity hedge fund will aim for a 15 per cent return with 8 per cent volatility. Funds of funds The other option for investors is a fund of hedge funds. As with any fund of funds, the aim is to diversify risk through a broad portfolio of holdings. Preservation of capital is generally an important consideration. The standard fund of hedge funds is multi-strategy. Based on a mix of the main investment approaches, the manager will position the portfolio to take advantage of conditions in the market. The fund of hedge funds gives investors access to leading hedge funds that otherwise may be unavailable due to high minimum investment requirements. Historically, hedge funds have delivered better risk-adjusted returns than other asset classes. Between 1958 and 1968, Alfred Jones’s portfolio returned more than 1000 per cent. In today’s volatile markets, a hedge fund delivering an absolute return of eight to 10 per cent a year is likely to outperform most other investment vehicles. They are more flexible than traditional long-only mandates and there are few investment restrictions. With ISAs and PEPs already available in the UK and approved fund of funds available in Germany from next year, hedge funds are fast becoming mainstream, albeit non-retail, products. Allan MacLeod is director of hedge funds at Martin Currie Investment Management

'In today's volatile markets, a hedge fund delivering an absolute return of eight to 10 per cent a year is likely to outperform most other investment vehicles'
Allan MacLeod, Martin Currie