The Beginners Guide To What A Hedge Fund Is

Hedge funds offer for the more sophisticated investor an investing alternative to main stream investment funds or investing directly in instruments such as shares, property of fixed interest securities.

They aim of the hedge fund manager is to create value using their skill and to not rely solely on the market or the growth over time of the instrument invested in to make profits. They are not constrained by such investment mandates or fund rules that they cannot short shares, use derivatives and arbitrage strategies.  All of which can be used by the fund’s manager to enhance short and medium term performance, as well as add diversification benefits in some situations.

Hedge funds are very similar to the well-known ‘managed fund’ in that investment funds are pooled and professionally managed.  They do generally differ in that the fund has far more flexibility in its investment strategies. The objective of a hedge fund can be summed up as providing investors with positive returns in most market conditions.

When you ask who this investment is best suited for, it is prudent to say not for the novice investor. It is not without its risks and best recommended for sophisticated and experienced investors who can analyse the risks associated with such investments. Hedge funds are constantly playing the balancing game of opportunity with risk and this is where the skill of the fund’s manager is paramount.

There are many different types of hedge funds. All have different features and risks depending on the fund’s strategy, the types of assets it invests in, where the assets are located, the analysis technology used and really importantly the managers’ skill, experience and knowledge.

Hedge funds endevour to produce consistently positive returns, irrespective of the direction the market is going in. The idea is to hedge against market declines, hence the name. They can also enhance returns by borrowing money

One of the main alluring features of hedge fund investment is that, when a manager knows his stuff and gets it right, they contribute a return that isn’t tied to local or global stock, property or bond markets. This provides diversity to an investor’s portfolio. However, if the manager gets it wrong, and this does happen, the fund could magnify the investors losses.

Alfred Jones is credited as the ‘inventor’ of the hedge fund, starting the first in the United States in 1949. He raised $100,000, including $40,000 of his own money, and set off to try and minimise the risk in holding long-term stock positions. He did this by short selling other stocks. This investing stratergy is now referred to as the long/short equities model. He also used leverage to enhance returns.

There are now thousands of funds around the world offering an ever-ballooning array of strategies, including currency trading, high intensity computer trading as well as derivatives such as futures and options, and not to forget the exotic twists that get thought up from time to time.

How Do You Invest In A Hedge Fund?

This area of investing has traditionally been reserved for the ‘high net worth’ individual who is seen to meet the market regulator’s classification of a ‘sophisticated investor’. One who is able to establish and analyse risk. The minimum dollar amount an investor needs is $50,000.

Australia’s hedge funds are low in number and dollars under management when compared to the likes of the United States or the United Kingdom. According to a report published by ASIC in 2015, there were 473 local hedge funds with about half of them managing just $50 million in investments.

If you’re considering an invest in a hedge fund, it’s important to do your research and seek professional advice first. That said, it’s good to remember that past performance is not an indication of future returns. There are also many factors to consider, such as frequency of income, the impact of tax relating to your circumstances, your age, your risk profile and investment goals.

Risks!

Hedge funds by their very nature, their diverse and sometimes complex investment strategies, use of leverage, short selling and derivatives, can pose real downside risks for investors when compared to traditional funds.  Investors need to prudently understand factors such as how their money is to be invested, the investment mandate, who is making the key decisions for the fund. This is not to also mention how the assets will be valued and when, how investors can withdraw their money, details relating to leverage limits, derivative use and criteria for stocks allowed to be short sold.

You need to know intimately what the fund’s strategy is and understand it. It goes also without saying that you need to feel comfortable with and understand all the key people involved in the management and running of the fund, as well as the liquidity policy (cash held component) to managing fund unit liquidity when people want to exit.

The history of problems is well documented caused by funds holding illiquid investments when large numbers of unhappy or fearful investors want to redeem their units. Some funds caught in this trap have required investors to accept that their investments can only be redeemed with an enforced notice period or be periodically redeemed so the cash flow crisis can be managed.

Fees need to be conserved carefully as they can add up and eat into your expected return. Typically, a fund charges in the order of 2% of assets plus a percentage of profits that can be circa 20%. It’s important for investors to understand how much of the performance return is being eaten away in fees. Also, the trading nature of hedge funds can also expose investors to higher tax being applied and professional advice relating to your circumstances needs to be sought.

Important

It cannot be reiterated enough; past returns are no guide for the future returns and the essential need to educate yourself as much as you can before contemplating adding a sophisticated instrument such as a hedge fund to your investment portfolio.

Author: Tony Adams

Tony Adams is a retired Australasian stock broker and has been a professional investor for over 30 years. He has held Authorised Financial Advisor status in New Zealand and RG146 Certification in Australia. The above article authored by him should be considered as General Advice in nature only and investors must seek professional advice relating to their particular circumstances when considering any investment into a hedge fund.