Hedge Funds, Do They Enhance Diversification and Reduce Risk?

Over the past years, an industry has grown around monitoring, interpreting and anticipating market cycles, for those who seek to gain from changes in the market. The hedge fund industry in recent times represents a radical departure from such thinking.

So-called hedge fund managers aim to generate profits in both rising and falling markets using strategies designed to perform in both market directions. They do this by strategies not generally available to traditional investment fund managers. The use of derivative instruments such as futures, options and techniques such as short selling are common. As a result, hedge fund investments may have little in common with traditional assets such as cash, bonds, property or shares.

A hedge fund can be described as a managed investment that has flexibility in terms of the instruments and markets it trades, and the way it rates these markets.  Like traditional investment managers, hedge funds invest largely in mainstream assets. What sets them aside is their strategic view on directional market risk. They tend to be highly individual in terms of their management style, strategy and risk/return profile.

Funds can be sub-divided according to the strategies followed and vary across asset classes, geographies and styles. Relative value arbitrage, event driven, or opportunistic and directional for example. Strategies can be highly sophisticated, requiring significant expertise and also be complex, analytical models and systems. For investors, gaining exposure to a wide range of these strategies is key.

There are other points that should also be considered such as;

• Performance, success or under performance is measured in absolute terms, not based upon a benchmark.
• Fees are generally performance-based, usually a fixed percentage above a stated threshold or hurdle rate.
• Personal financial stake. Hedge fund managers typically invest their own money in the funds they manage, obviously acting as an incentive to achieve positive returns without undue risk.

Hedge funds are far from new. For many decades, institutional and high net worth investors able to meet the high investment minimums that hedge funds typically required added to their portfolios’ diversification, and more importantly, reduced downside risk and increase long-term investment returns via hedge funds.

With the advent of funds of hedge funds, which offer lower investment minimums and highly diversified hedge portfolios, these potential benefits are now accessible to mainstream investors.

Prolific growth has occurred in the total assets under management during the past few years.  These new investment opportunities have promoted some investment professionals to see whether they can confidently apply the criteria they use to assess traditional asset class investments to hedge fund investments.

Investment decisions drive returns and an assessment of  manager capability must be central when evaluating new opportunities.

Important issues to consider before choosing include:

• Is the team led by experienced professionals in this complex sector?
• Is the investment portfolio actually managed by these experts, or are the portfolio managers reliant on external advisers for key decision-making inputs?
• Does the team have access to high quality research covering all asset classes and a structure for integrating it into decision-making?
• The hedge fund industry is global in its scope.  Does the manager have access to global research and resources?
• Is the manager’s investment process clear?  Does this process indicate that the manager engages in regular dialogue with the funds they invest in?

It is clear that lack of correlation with conventional assets means that hedge funds can enhance diversification and may reduce volatility within investment portfolios. However before embracing a wholesale change of asset allocation ensure your understandings of the taxation, fees and investment terms are complete.