The term 'hedge fund' includes a multitude of investment strategies with a broad range of risk-and-return objectives. There is often a cliched and largely inaccurate view of hedge funds as being risky, technical and occasionally morally bankrupt vehicles. However, in reality only a very small number of hedge funds are 'global macro' funds where larger and perhaps riskier positions are taken. Hedge funds currently represent only 5% of the US mutual fund market but as the market both here and in the US is better understood and performance improves, market share is set to grow. There is currently around $400bn invested in 5,200 hedge funds worldwide. Is this increase in the popularity of hedge funds, despite the dramatic collapse of Long Term Credit Management (the hedge fund that was bailed out by American financial institutions) for instance, reflecting a shift in investors' attitude to risk? It is apparent that the risk inherent in these types of alternative investment strategy is dependent on both the investment style and the extent to which it is geared. It is important to appreciate that a low-risk, highly geared investment policy can be more vulnerable than a high-risk policy with less gearing. The reward for taking more risk should be a higher level of return. It is accepted that as the financial horizon appears more stable, as has been the case, particularly in the US, investor appetite for risk increases. Traditionally risk-adverse investors, as a result, may end up with higher levels of risk than they had initially expected or than they would permit in less optimistic times. Hedge funds can be grouped into four major categories of investment strategy: - Market-neutral or relative-value strategies are not dependent on the general direction of market movements. Returns, as a result, are not correlated with benchmark indices. - Event-driven strategies are based on the actual or anticipated occurrence of a particular event such as a merger, a bankruptcy announcement or a corporate reorganisation. Again returns are relatively unaffected by the direction of equity and fixed income markets. - The third kind are long or short strategies investing in equity and/or fixed income instruments, combining long investments and short sales to reduce market exposure and isolate the performance of the fund from the performance of the asset class as a whole. This strategy is more affected by, as opposed to correlated with, benchmark indices. - Tactical trading funds speculate on the direction of market prices of currencies, commodities, equities and/or bonds in futures and cash markets. This is the most volatile strategy in terms of performance. The correlation of returns with traditional benchmarks is low. Investment returns, volatility and risk vary enormously according to differing investment strategies. Most hedge funds define risk as a loss of principal, as opposed to the tracking error of portfolios relative to a benchmark. In most cases, hedge fund total returns are primarily driven by specific security decisions rather than the performance of an asset class and portfolio beta (measures the sensitivity of the price of an investment to movements in underlying markets). Typically they are domiciled in offshore centres such as the Cayman Islands and Bermuda. This makes them unrestricted by the regulation of onshore markets. Because of this they are not permitted to promote or advertise themselves widely. The ability to take long and short positions reduces their correlation to market indices and can make the funds effective in choppy markets. They have the option to gear portfolios by borrowing against the assets in the fund. Generally they have a higher minimum investment which deters the unsophisticated, smaller investor. Within the industry, arguments in favour of hedge funds focus on qualities like the ability to tailor portfolios, providing institutional funds with a more extensive range of income, growth and risk attributes. Larger hedge funds can benefit from cheaper dealing costs, superior information and specialist knowledge and can provide market liquidity, upon which other investors rely. The volatility seen in global markets over the last year has seen the demand for hedge funds increase. This is because, if properly invested and organised, these funds are able to take advantage of volatility. For private individuals, absolute may be preferable to relative returns and the benefits of diversification derived from investing in. different baskets of securities. But sometimes hedge funds are ill-defined, and often investors are unsure what these funds are invested in at any one time. Also, these types of strategies are not for investors requiring security of income or capital. They are not suitable for smaller portfolios unable to achieve diversification of style. For alternative investment strategies, including hedge funds, there is little evidence of predictable performance in average returns or in correlation with stock and bond returns. Traditionally hedge funds were seen as a difficult vehicle for pension funds to invest in, but Calpers (California Public Employees' Retirement Systems) in the US has recently committed to this type of investing. This sector has also benefited from increased capital supplies from a new generation of entrepreneurs, grown from the recent craze of hi-tech listings, who want the glamour and excitement that hedge funds are perceived to provide. In spite of all the bad publicity, hedge funds are slowly becoming more mainstream. - Jane Tanner is editor of publications at Cazenove Fund Management.
As well as increase capacity and performance
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