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What you need to know about hedge funds

May 27, 2009 16:06 IST
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Did you know that that all hedge funds are not volatile? The popular misconception is that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage.

In reality, less than 5% of hedge funds are global macro funds.

But before we go in to what the benefits of hedge funds are, and whether they are an option for your investment portfolio, let us understand clearly exactly what a hedge fund is, and how it works.

What is a hedge fund?

A hedge fund is an investment vehicle that pursues absolute returns on its underlying investments, which includes stocks, bonds, commodities, currencies, derivatives, etc., while applying non-traditional portfolio management techniques such as shorting, leveraging, arbitrage, swaps, and so on.

From this you can derive that to 'hedge' means to manage risk. Where, for example, a money manager makes an investment that is speculative, and also makes an allocation that balances any negative performance from his speculative position, this is hedging position.

The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

What qualifies as a hedge fund?

Funds that utilise a variety of financial instruments to reduce risk and enhance returns, as well as those that are flexible in their investment options

Funds that have as an objective consistency of returns and capital preservation rather than magnitude of returns

Funds that are not only managed by experienced and diligent investment professionals, but those that trade only within their area of expertise

What strategies does a hedge fund employ?

Understand that the return achieved by a hedge fund manager does not necessarily rely on presiding market conditions, but is usually attributed to that manager's ability or skill. This is because hedge fund managers try to remove some market exposure and aim to produce a positive return irrespective of market direction.

They operate in fairly small areas of the market to reduce volatility by greater diversification. Some of the methods that hedge fund managers employ to achieve these ends are:

Selling short: This involves selling shares without owning them, with the aim of a buy-back at a future date at a lower price, in the expectation that their price will drop.

Using arbitrage: This seeks to exploit pricing inefficiencies between related securities.

Trading options or derivatives: This includes contracts whose values are based on the performance of any underlying financial asset, index or other investment.

Investing in anticipation of a specific event: Events can include mergers, takeovers, spin-offs, and so on.

Investing in deeply discounted securities: This includes companies in financial distress or bankruptcy, where securities are below the liquidation value.

Leverage is the use of borrowed funds at a fixed rate of interest in an effort to boost the rate of return from an investment. Increased leverage causes the risk and return on an investment to also increase.

Who invests in a hedge fund?

Simply, if you cannot afford to lose the money you invest then you should not be looking at hedge funds as a viable investment route.

Traditionally, pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimise overall portfolio volatility and enhance returns.

What are the benefits of investing in a hedge fund?

If you can invest in a hedge fund, then you will learn that many of them can generate positive returns in both rising and falling equity and bond markets. Including hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns.

Academic research also proves hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds also allow for more diversification than traditional investment routes, and they work best as a long-term investment solution, because they eliminate the need to correctly time entry and exit from markets.

Is hedging right for you?

As the interest in hedge funds has grown, a similar trend has developed to copy the mainstream financial markets: the "investable index". These indices allow investors to allocate money across a range of strategies and managers, with the aim of generating returns that match one of the well known indices.

While hedge funds aim to reduce market volatility, they can still lose money for themselves and their clients, or provide disappointing returns. Hedge fund managers can also charge very high fees, and some funds are not at all transparent, because they do not reveal their trading strategies.

You therefore need to choose carefully, and decide if an index return is really the right target, and whether the strategy employed is the right one for you. Do also remember that hedge funds are only one option within an ever increasing range of investment strategies. Private equity, property and commodities are all viable alternatives in the ideal investment portfolio.

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