Investing in Hedge Funds

The fears of hedge fund troubles will never go away. Most experts agree that hedge funds are part of the solution for any well-diversified portfolio. But still, some local private and other institutional investors are reluctant to use them, even if their regulations allow. For some, hedge funds are synonymous with “risk”.

Indeed, hedge funds have been featured regularly in the mainstream news, and not surprisingly much of the reporting in the media has been negative or rather sensational in my view. Of course, a few investors from my meetings are ahead of others that they have already gained some real investment experience with hedge funds.

Hedge funds may invest and trade in many different markets, strategies and instruments with various risk characteristics. Hedge funds employ innovative trading strategies. Their strategies can include taking both long and short positions, using leverage and derivatives. Some may only consist of a small investment team or may depend on one or two key persons for their investment success.

Originally, these alternative products were just for family offices. Then high networth individuals regularly via a private bank joined the party. Institutional investors including pension funds were next to come in. Now, savvy retail investors are being provided with the opportunity to jump on the bandwagon. 

Many of the small hedge fund start ups are being founded by the talent flight from large institutions. These star traders are lured by the freedom of active market trading, reduced infrastructure and red tape and not least the lure of attractive performance fees. Well, money will always go where it is treated best.

The majority of hedge fund compensation is directly related to performance. When a hedge fund is unprofitable for a year, it typically loses most of its fee income. Successful hedge fund managers can make a lot of money due to this profit-sharing structure. Others who are not good enough to survive the competition will probably have to close their doors and return monies to their investors.

Contrary to what has been regularly reported, not all hedge funds are risky that they use a momentum approach and place large bets on stocks and currencies. Some hedge fund styles with effective risk control models provide lower volatility and also add excess returns.

Conventional long-term investment is based on the assumption that markets will deliver long-term “high” returns. A critical difference between hedge funds and traditional mutual funds is the former are looking for absolute returns (regardless of market conditions) where the latter normally measure performance against a benchmark.  For the traditionalists, this is an acceptable approach when markets are strong but clearly is less than desirable in either flat or bearish markets. 

Whichever way the markets move, the good hedge fund managers unlike their old-fashioned competitors should continue to prosper. However, investors need to know what is going on out there. This is because hedge fund strategies’ correlation with the main asset classes differs significantly depending on the innovative strategy. Some strategies may be particularly effective during the macroeconomic cycle.

There is still need for research and understanding of hedge funds before investors feel more comfortable investing in them. Investors reviewing opportunities in them should be aware that there are risks to consider. 

Extensive initial and ongoing due diligence is needed to deal with problems involving transparency, liquidity and the sheer range of funds in existence. Large institutions can do their own due diligence, but for private individuals - most of whom do not have the resources or the experience to do so, they should engage the relevant professionals for advice before investing in hedge funds.

Do research on what risks the manager takes and how he or she expects to make money for them. Also, the fund they are investing in should complement their existing investments.

Whatever your thought of hedge funds, put it aside for a moment. Open your mind to a new perspective that has helped investors to diversify their assets during both good and bad times.