Hedge funds

Hedge funds - a useful addition to traditional investment

Hedge funds aim to achieve a set target return and have an 'absolute' benchmark, rather than traditional funds that aim to outperform an equity or bond market index which are 'relative' benchmarks.

By aiming to deliver a consistent target return, regardless of market conditions, hedge funds provide a useful complement to traditional equity and bond funds as a diversifier with many displaying lower volatility and correlation than equity indices.

The first hedge fund created in the 1950s is typical of the majority of hedge funds operating as Equity Long/Short funds today. These funds typically have high concentrations of the manager's own money in the fund, with the attraction that they have more flexibility to protect and enhance the capital than a traditional equity manager.

Fundamental to this practice is the ability to 'short' sell.

Hedge funds can generate returns in a falling market

Equity Long/Short managers select stocks that they envisage will appreciate in value (just like any traditional fund manager), but in addition they can protect capital if they think that the market will falter.

Buying a derivative instrument such as an index future or PUT option can generate returns in falling markets. This concept can be further enhanced by shorting individual shares rather than an index. Hedge fund managers may also choose to have far larger cash weightings than traditional equity managers.

The principle of 'shorting' securities can be applied to other financial instruments and can lead to other strategy specialisations apart from Equity Long/Short. For example, some managers concentrate on mis-pricing anomalies in the fixed income markets only (Arbitrage).

Other managers may have a broader mandate, investing in both developed and emerging markets and will take a 'top-down' macro-economic view based on their interpretation of interest rates, economic policies and inflation. The portfolio is then positioned accordingly through currency, bond and equity holdings (Global Macro).

A fund of hedge funds?

One of the best methods to gain hedge fund exposure is through a fund of hedge funds as it dilutes the individual manager risk by holding a number of underlying funds. The risk can be further dissipated by investing in managers across a wide spectrum of strategies (for example, Equity Long/Short, Arbitrage & Global Macro), which will cover currency, equity and bond markets on an international basis, rather than reliance on one strategy or sector in isolation.