1. October 2014
Hedge Funds - Demystified
Why call it a Hedge Fund? - The first hedge fund started
in the USA in 1949 by Alfred Winslow Jones and the term
was first coined in 1966 to describe Jones’s unique
investment style in an article written by Carol Loomis
called ‘The Jones Nobody Keeps Up With.’
Published in Fortune Magazine, Loomis’ article lionized
Jones and his approach. For example, he would buy stock
he believed to be undervalued and, to ‘Hedge’ against or
reduce exposure to the market itself; he would sell short
another stock that he believed to be overvalued.
What is a Hedge Fund? - A hedge fund is a fund that can
take both long and short positions, use arbitrage, buy and
sell distressed securities, trade options or bonds, and
invest in just about any opportunity in any market where
it foresees gains at reduced risk. A hedge fund is an
investment structure for managing a pool of assets in a
relatively unconstrained manner. Managers can invest in
not only traditional securities but also derivatives,
commodities and sometimes use borrowed money.
There are many different hedge fund styles and strategies
and within the range, investment returns, volatility and
risk can vary enormously. Some strategies have very low
correlation with equity markets and aim to deliver
consistent returns with very low risk. Other strategies
may be highly leveraged and speculative in nature,
producing higher volatility and higher risk than the
underlying market.
What makes them different? – Using any strategy other
than simply buying-and-holding stocks or bonds, hedge
funds aim to produce ‘Absolute’ (i.e. positive) returns
each year regardless of market performance. Hedge
funds do not depend simply on asset appreciation to
generate a positive return and the primary determinant
of their performance is the expertise of the individual
manager.
A hedge fund manager’s skill contributes up to 80% of a
fund’s returns and performance of the underlying
markets only 20%. The reverse is true of a traditional
mutual fund manager, as even the best such manager
will consistently lose money if the overall market is
deteriorating.
Depending on the fund’s strategy, the manager may hedge
certain risks from the portfolio by simultaneously investing
in an offsetting or opposite position, so that if there is a
general market downturn the fund’s losses could be
minimised.
In terms of fees, hedge funds strive to achieve positive
returns each year and these Managers are paid on absolute
performance, rather than most Fund Managers who simply
buy, then hold, and does nothing to preserve capital or
avoid losses in the event of a market downturn. Hedge
funds also eliminate the need for investors to time their
entry into and exit from the market.
Because of their low correlation with other investments,
hedge funds also provide important diversification and
reduce the overall risk of a portfolio that contains many
different asset classes (stocks, bonds, property etc).
Therefore, quite simply a hedge fund provides the
opportunity to generate positive returns without traditional
assets such as, bonds, property or equities gaining in value.
Whilst hedge funds acquired a bad name in the global crisis
and certainly some failed and were well publicized.
However, a good number performed extremely well (when
almost every asset class failed) and with institutional
inflows rapidly rising, it would be very short sighted to
ignore this sector now.
Julian Galvin, Executive Director - Investment
Member of Investment Committee, Tyche Group Limited
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