Hedge funds 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 or absolute return fund is to provide investors with positive returns in most market conditions. Many hedge fund managers also invest a significant proportion of their own wealth into the funds they manage.
Overview
Hedging is like insurance in that it is paying a small price to protect against a possible loss. If you have an investment, hedging is buying something else to offset a possible loss in that investment.
For example, if you buy shares in Company A expecting them to go up, you could hedge to protect yourself against loss if they go down. If there is a option market in Company A’s shares, then one method of hedging is to buy Put options which enable you to sell the shares in the future at a set price. If the shares go down drastically, then you can exercise the put options and reclaim the majority of your original investment, less of course, the cost of buying the put options. There are many other hedging strategies but all involve doing something on top of simply buying and selling shares.
It is important to note that while hedging is attempting to reduce risk, the goal of most hedge funds now is to maximize the return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market. Nowadays, hedge funds use dozens of different strategies, and it isn’t accurate to say that hedge funds “hedge risk”, when, in reality, many carry more risk than a simple index fund.
There are relatively ‘vanilla’ funds which simply use these hedge fund type techniques to smooth investment returns through the cycle. A simple Australian shares fund might use short selling or put options in a classic hedge in times of poor share market conditions. In this case, you may well consider the investment as equivalent to any other equity managed fund.
Hedge funds tend to have a low correlation to the performance of traditional asset classes such as shares. Because returns are generated from employing different investment strategies, hedge funds can provide diversification when blended into a traditional investment portfolio of stares, property and fixed interest. They can provide useful diversification when part of a diversified, prudent SMSF investment portfolio. However, noone would argue that a self-managed super fund should have a big exposure to such funds. You might consider putting up to 5% of your fund into selected funds but even then, this should only be the action of a more sophisticated investor.
For an opinion on the duties of SMSF trustees when investing in hedge funds, refer to this APRA publication.
Any funds with leverage or gearing (borrowings) should be treated with caution.
Because of regulations in various markets, you may find that a particular fund is only open to sophisticated or wholesale investors and requires a very large initial minimum investment and may have penalty entrance/exit fees designed so that investors keep their money in the fund for reasonable periods. Recently there have been a number of hedge fund “fund of funds” products introduced for retail investors allowing individuals to access hedge fund managers for amounts as little as $1,000 or $5,000.
Features
The table below shows some general differences between a typical hedge fund and a typical traditional managed fund.
Features |
Hedge Fund |
Traditional Fund |
Investments |
Shares, bonds and derivatives |
Shares |
Profit from rising share prices |
Yes |
Yes |
Profit from short -selling |
Yes |
No |
Able to reduce or eliminate market-related risks |
Yes |
No |
Manager actively manages portfolio risk |
Yes |
No |
Manager has own money invested in fund |
Yes |
No |
Able to concentrate portfolio with large investments |
Yes |
No |
Can use gearing or can fully invest in cash |
Yes |
No |
Investment performance |
Driven by manager |
Driven by market |
Managers’ fees |
Based on performance |
Based on fund size |
Performance assessed on |
Absolute performance |
Relative to index or similar funds |
For a good introduction to Hedge Funds refer to this ASX booklet.
History
Did you know that an Australian is credited with starting the first hedge fund in 1949. For those who are interested explore the history of hedge funds in more detail here.
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Alfred W Jones, who was born in Melbourne in 1901, is credited with creating the first hedge fund in New York in 1949. Jones hedged his portfolio by buying shares whose price he expected to increase, and ‘short’ selling others whose price he expected to decrease. Short selling is selling shares that you don’t actually own which means that you are going to have to buy them at some point in the not too distant future. While you know the price you have sold them for, you don’t know what you are going to have to pay for them and is an inherently risky strategy but makes money if the share price goes down. Jones referred to his fund as being “hedged” to describe how the fund attempted to profit from individual share’s performance while protecting against an overall market decline. This is now known as a classic long/short strategy. Jones combined the hedged investment strategy with leverage and with fees based on performance. By the mid 1960s, Jones’ fund was reported as outperforming every other fund on the market over the previous five years by high double digits despite his 20% performance fee and thus the hedge fund industry was born. By 1968 there were almost 200 hedge funds, and the first fund of funds that utilized hedge funds was created in 1969 in Geneva. Over the next twenty or so years various strategies were tried but many led to heavy losses and fund closures and hedge funds lost popularity. However hedge funds received renewed attention in the late 1980s, following the success of newer funds, particularly Julian Robertson’s Tiger Fund. Thousand of funds were started offering a wide variety of exotic strategies, including credit arbitrage, distressed debt, fixed income, quantitative, currency trading and derivatives. One of the most famous hedge fund events was in 1992, when the Quantum Fund, run by international financier George Soros, helped force sterling out of the European Exchange Rate Mechanism. A notable collapse was when Long-Term Capital Management with US$120bn under management and Nobel prizewinning economists on the board, lost $4.6 billion in less than four months during the Russian financial crisis in 1998. The fund was closed a short time later. In fact, by the turn of the century, many of these hedge funds had failed, including the famous Tiger Fund. But hedge funds have again gained popularity and now manage billions of dollars from large institutional investors including pension funds, university endowments and foundations. In April 2011, assets under management were estimated at almost $2 trillion. |
Australian hedge funds
The Australian Trade Commission, in a September 2010 report, estimated that Australian hedge funds had $46.8 billion of assets under management. Some 64 per cent or 48,000 investors in hedge funds and funds of hedge funds were individual investors including self-managed super funds.
While Platinum Asset Management is often seen as a traditional managed fund specialising in international shares, strictly, because it can use short selling, it can be considered a hedge fund. This would make it Australia’s largest hedge fund with some AU$17.5bn under management, almost exclusively from retail investors. It was founded by Kerr Neilson and other former employees of Bankers Trust Australia in 1994.
The 2008 GFC hit many hedge funds hard with some high profile failures in Australia such as Basis Capital.
Some current Australian hedge funds are available from:
Blue Sky Apeiron (BSA) Global Macro Fund
Equity Trustees SGH Absolute Return Fund
A 2010 performance table which lists many funds can be found here.
For more information visit the ASX page on Absolute Return Funds.
Strategies
Modern hedge funds typically use aggressive strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns either in an absolute sense or over a specified market benchmark. Hedge funds have been seen to outperform in bearish markets but all strategies have weaknesses. Hedge fund returns tend to be negatively skewed, which means they are mostly characterised by positive returns but have a few cases of extreme losses.
While many hedge funds have a specific, single strategy, some are “funds of funds” which invest in various underlying single-manager hedge funds. You may see a particular fund referred to as a hedge fund simply because its investment mandate allows short positions. Funds may attempt to maximise gains through leverage, that is borrowing money over and above money invested with the fund. Also a fairly common strategy is a simple long/short approach for an equity fund with 130% long and 30% short positions, leaving a net long position of 100%. You may see a fund described as “market neutral” or “absolute return” which is any strategy that attempts to fully eliminate market risk and be profitable in any market condition. A fund may be a “market timer” where the manager switches between particular investments and money markets on the basis of anticipated movements. A general term describing any fund is “opportunistic” which typically describes an aggressive fund simply trying to make money in any way possible.
Single strategy funds are generally said to fall into four main categories: global macro, directional, event-driven, and relative value. More information on each of the categories can be found here.
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Global macro Global macro fund managers take views based on global market events and trends to identify opportunities for investment. They may have experienced managers who identify and select investments; or use mathematical models with limited human discretion. A fund attempts to profit from following trends or attempts to anticipate and profit from reversals in trends. Funds might trade in currencies, commodities, futures, equities and financial instruments. They may take both long and short positions, allowing them to make profit in both market upswings and downswings. You may see the abbreviation “CTA” which is short for Commodity Trading Advisor. CTA’s generally trade commodity futures, options and foreign exchange and most are highly leveraged. Directional Directional funds have a focus such as long/short equity, where long equity positions are hedged with short sales of equities or equity index options. Funds may use quantitative techniques or computer models. Emerging markets funds focus on markets such as China and India. Sector funds focus on specific areas such as technology or healthcare or resources. Funds may focus on “growth” or “value” stocks. “Growth” companies are expected to grow earnings per share and therefore share price and generally have a high P/E ratio, with low or no dividend and are often smaller capitalisation companies experiencing rapid growth. “Value” company shares are perceived to be undervalued or cheap shares, out of favour with the market and perhaps, misunderstood by analysts. The fund manager believes that the share price of these shares will increase as the “value” of company is recognised by the market. Event-driven An event-driven investment strategy looks for business activity such as acquisitions. Funds try to take positions expecting price movements because of the anticipated event. For example, a fund might buy the heavily discounted bonds or loans of a company facing bankruptcy with the expectation that they can prevent the bankruptcy and profit from the repayment of the loan. A fund might try to arbitrage by buying and selling the shares of merging companies if they are mispriced however there are obviously risks if the merger or acquisition does not go ahead. Hedge funds occasionally take a large positions on the share register and use the ownership to participate in the management. Some funds specialise in companies involved in major lawsuits. Relative value Relative value attempts to take advantage of relative discrepancies in price between shares. The price discrepancy might be between related shares, the underlying company or the market overall. These strategies do not have exposure to the market as a whole. The fund might look for two matching investments and go long in one and short in the other. There may be pricing inefficiencies in fixed income, between stocks in the same broad sector, between convertible shares and the underlying stock, etc. |
Fees
Investors in hedge funds typically pay a management fee and an annual performance fee when the fund beats particular targets. Typically management fees might be from 1% to 4% with 2% as standard and performance fees are from 20% commonly but can be up to 50%. Performance is usually calculated using either a high water mark or hurdle rate.
A high water mark means that the fee percentage only applies to amounts in excess of the previous high in net asset value. If a fund has not performed very well, this can provide motivation to close a fund and start a new fund rather than attempting to recover investor losses without fees.
A hurdle rate means that the fee percentage only applies to annualized performance in excess of either a benchmark rate or a specified percentage. Some funds calculate fees on the entire annualized return once the hurdle rate is cleared, while others calculate fees just on the returns above the hurdle rate.
High performance fees have been criticised by investors such as Warren Buffett. Because hedge funds share only the profits and not the losses, he believes there is an incentive for them to take high risks.
There may be quite large differences in the buy/sell price of units to discourage short term investing.
Deciding to invest
In a recent discussion paper, ASIC commissioner Greg Medcraft said, “Hedge funds, because of their diverse investment strategies, complex structures and use of leverage, short selling and derivatives can pose more diverse and complex risks for investors than traditional funds… Investors need the 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.
You need to understand how much of the performance is being taken away in fees and whether you believe that the performance that your investment returns is commensurate with the risks involved.