Hedge funds have acquired a fearsome reputation in recent years, largely
because people still remember how George
Soros’s Quantum Fund helped to force the pound out of the European
exchange-rate mechanism in 1992.
The irony is that, despite their high-risk image, hedge funds were originally
designed to protect against risk, rather than maximise it.
So here is a quick explanation of what hedge funds are, how they operate and
how you can invest in them.
What is a hedge fund?
An investment that aims to make money year in, year out, no matter what the
financial climate (known as an absolute-return
strategy). How to define hedge funds is tricky because it is an umbrella
term for a huge range of different investment strategies and risk levels.
One thing that they have in common is that wealth preservation - not losing
money - comes very high up the list of priorities.
Why do they seem so scary?
Their sheer size (many funds are worth billions of pounds) is enough on its
own to command attention, but it is the frequency with which they trade that
gives them a profile even bigger than their size alone would merit. Market
experts reckon that hedge funds account for as much as 50 per cent of all
trades on the London Stock Exchange.
When hedge funds combine to bet on a particular outcome, as they did with the
pound in 1992, even governments can find themselves powerless to resist the
momentum they generate.
How do hedge funds work?
They use a number of strategies to make money for investors. Perhaps the most
notable is the long-short equity strategy. This allows the fund manager both
to "go long" - the traditional approach of buying an asset in the
hope that it will rise in value - and to "go short". The latter is
when the fund manager sells a borrowed asset in the hope of buying it back
more cheaply later.
Another approach is arbitrage, where the fund manager takes advantage of
anomalies in the pricing of assets. For example, when a company's shares are
quoted in two different countries, arbitrageurs may see a slight advantage
in buying the shares in one country rather than the other. To see arbitrage
in action, use an online
calculator.
A third method of making money is to take a significant stake in a company in
the hope that a profitable takeover or management shakeout will follow.
Are hedge funds suitable for the man in the street?
There are a number of hurdles that a typical private investor needs to clear
before putting money in a hedge fund. The first is that the initial
investment required is usually very high. It is rarely less than £50,000 and
can be £1 million or more, which rules out all but the wealthiest investors.
Hedge funds are based offshore and are not regulated by the Financial
Services Authority, so the usual warning about seeking advice before
buying applies with extra force in this case.
Although not all hedge funds are high-risk, some of the strategies used by
some of the funds undoubtedly are. For example, the use of specialist
instruments known as derivatives offers highly geared bets on the future
price of things such as shares or commodities, and investors need to be sure
that they appreciate the level of risk. Hedge funds typically use leverage.
This involves borrowing additional money to increase the size of the bets
they are taking.
How much does all this expertise cost?
Quite a lot. Hedge funds typically charge 2 per cent a year in annual fees,
plus a performance fee of 20 per cent or more of any rise in the fund’s
value. Performance fees are rewards to managers for achieving a certain
level of return. The idea is that by offering these incentives the fund
ensures that both the managers and the investors have a strong interest in
the fund doing well.
Does the performance of these funds justify the high fees?
It is impossible to give a blanket answer to that question, but it is
certainly fair to say that the high charges act as a drag on performance.
Last year the average return on European hedge funds was a little less than 10
per cent, according to HedgeFund
Intelligence, the industry information group. This compares with the
return of 18.1 per cent posted by ordinary European equity funds.
However, hedge funds fared much better in the bear market of 2001 and 2002.
While the stock market was down 45 per cent, hedge funds were up by between
1 per cent and 2 per cent. Because hedge funds aim for absolute returns,
they tend to perform better than the stock market in bad times but less well
in good times.
How do you go about buying a hedge fund?
Your financial adviser should be able to point you in the right direction, but
you will need a substantial initial sum and could be buying into a very
risky investment.
Charles Cade, of Winterflood Securities, the stockbroker, says that he would
not recommend direct investment in hedge funds. A better route would be a
fund of hedge funds. These invest in a number of different funds and there
are more than 20 listed on the London
Stock Exchange.
But these, too, have drawbacks. They usually charge another layer of
performance fees on top of those levied by the underlying hedge funds, and
like hedge funds, they are not regulated by the FSA, though the watchdog is
thinking about bringing some funds of hedge funds under its regulatory
umbrella.
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