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Are all hedge funds risky? Not necessarily so. Hedge funds aim to profit from
changes in global economies, using leverage and derivatives to accentuate the impact
of market moves. Global macro funds can be extremely profitable, but are often volatile,
and produce occasional sudden falls. Hedge funds typically use borrowed funds to
leverage their returns. They also adopt common hedging strategies to minimize risk.
However, not all hedge funds are the same due to their different investment strategies.
Hedge fund managers hedge against market downturns - what does it mean to "hedge"?
Hedging means managing risk. A hedge fund manager employs hedging techniques in order
to mitigate a particular type of risk. For example, in a declining market, risk can
be hedge by selling securities in equal proportion to one's long (buying) exposure.
Tools and techniques often used include short-selling securities, buying and selling
securities options, futures, commodity, currency futures, etc. Ironically, most mutual
funds or unit trusts cannot execute short positions (opposite of long). Below outline
the difference between hedge funds and conventional funds such as mutual funds.
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Table 1. General comparison between
mutual funds and hedge funds
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Mutual Funds
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Hedge Funds
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| Performance is measured against relative
benchmark or to other mutual funds in the sector. |
Hedge funds attempt to make absolute
returns under all circumstances - regardless of benchmark's performance. |
| Highly regulated. Limited investment
strategies as the use of leverage is generally restricted. |
Unregulated. The use of various hedging
strategies such as short-selling and other derivatives are allowed. |
| Remuneration is generally based on a
percent of assets under managed. |
Remuneration is based on performance
and a small fixed fee. |
| Performance is dependent of the direction
of markets. |
Performance is not dependent on the direction
of markets. |
Investment returns and risk levels vary significantly amongst the different hedge
fund strategies. Some strategies not correlated to equity markets are able to produce
consistent returns with lower risks while others may be more volatile than traditional
funds.
Massive losses of hedge funds run by superstars such as George Soros (Quantum) and
Julian Robertson (Tiger) in the 1994's has given rise to the myth that hedge funds
are a high return high risk strategy. However, in reality, less than 5% of hedge
funds are global macro funds like the Quantum, Tiger and Strome. Most hedge funds
use derivatives only for hedging and many conservative funds do not use derivatives
or little/no leverage at all.
A vast majority of hedge funds emphasize consistency of returns rather than magnitude
as their primary investment goal. The ability of hedge funds to remain healthy especially
during periods of sharp market corrections demonstrates that they can provide a hedged
performance.
U.S. hedge funds strongly outperformed the leading market indices in October 1997,
a period in which global financial markets were rocked by panic selling. According
to Van Hedge Fund Advisors International, the average U.S. hedge fund lost approximately
0.6% compared to the DOW (-6.3%), the Nasdaq (-5.4%), the Russell 2000 (-4.4%) and
the S&P 500 (-3.3%).
A successful hedge fund usually blends various strategies and asset classes to create
a more stable long-term return. Return and risks can be minimized by a mixture of
underlying strategies. It is certainly critical for wise investors to understand
the wide range of strategies found in the hedge fund universe and their differing
degrees of risks and returns.
Traditional style portfolios of stocks and bonds could benefit in terms of returns
and risks with the addition of hedge funds. Investing in hedge funds tend to be favored
by high network investors including many Swiss and private banks. Many endowment
and pension funds in the western world allocate assets to hedge funds. To sum up,
the growth of hedge funds reflects the importance of this alternative investment
category for investors.
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