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Hedge your bets

Not so long ago, the mere mention of hedge funds to some investment professionals would have provoked an immediate and negative reaction. In much the same way that the derivatives industry became stigmatised by the events surrounding Nick Leeson in 1995, hedge funds&#39 reputation originated from the exploits of the big global macro funds, such as George Soros&#39 flagship Quantum fund, which stood accused of destabilising currency markets.

As a consequence, both derivatives and hedge funds became good whipping boys when attributing blame in times of market turmoil.

However, this view has been largely reversed in the case of hedge funds as a result of the growing realisation that these funds can produce positive returns without taking excessive risks.

In their original incarnation, hedge funds seek to eliminate market risk as far as possible and capture returns solely through manager skill and style by adopting a long/ short strategy.

That is, by taking both long and short positions in a portfolio of carefully selected securities without predicting or relying on the direction of the broader market. A long position is taken by simply purchasing a security, or a derivative in the underlying security, while a short position is created by either selling a borrowed security in the expectation of purchasing it at a lower price at a later date, or by selling an equivalent derivative.

An article appearing in a magazine in 1986 on the spectacular performance of Julian Robertson&#39s Tiger fund set the scene for the exponential growth that was to be experienced over the next 16 years. Worldwide, the hedge fund market is now worth about $500bn (£350bn). About 90 per cent of the 6,000 available hedge funds are based in the US, mainly in New York, with the remainder located in offshore financial centres.

European institutional investors have also begun to dip their toes into this alternative pool of liquidity, UK pension funds and charitable funds included.

Hedge funds differ from conventional long-only investment funds in many respects.

In the US, hedge funds have traditionally been set up as private limited partnerships with up to 500 partners to escape SEC regulatory investment restrictions and disclosure requirements.

The fund manager acts as the general partner while the investors become limited partners. Most non-US-based hedge funds, however, assume an open-ended unauthorised collective investment scheme structure and are typically established in those offshore domiciles with comparatively light taxation and regulatory regimes, such as Bermuda and the Cayman Islands.

The minimum initial investment into a hedge fund ranges somewhere between $100,000 and $1m. Most hedge funds also impose a limit on the size to which they can grow so as to keep the fund nimble. The most successful funds have been known to close their doors to new investment within a matter of months after launch.

Being an unregulated investment medium, hedge funds have complete investment flexibility in terms of where, how and in what assets they decide to invest.

In addition to the traditional asset classes, hedge funds also take positions in commodities, currencies and mortgage-backed securities.

They can borrow in credit markets and employ derivatives to potentially enhance returns. Regulated long-only open-ended investment funds can only use derivatives for efficient portfolio management, mainly hedging and asset allocation although investment trusts can leverage returns through borrowing.

They are geared to absolute returns and the avoidance of losses whereas the vast majority of regulated long-only investment funds concentrate purely on relative returns. However, against a backdrop of declining equity markets, the recent introduction of focus, or themed, long-only funds has started a trend among retail investment funds in moving away from benchmarking towards absolute performance.

Given their ability to short and gear positions, hedge fund managers are arguably more disciplined than their regulated counterparts in monitoring risk.

As well as putting stop-loss limits in place, value at risk models are typically used in order to quantify the risk of capital loss over a defined period taking account of the probability of extreme events.

Generally speaking, by employing dynamic trading strategies, they lower the volatility of holding conventional portfolios, in much the same way that long-only global themed funds do, owing to their low correlation to world equity, bond, currency and commodity market movements. This should in turn result in a superior risk-return trade-off.

Rather than buying an asset class, hedge fund investors instead buy a skills&#39 set. The fees levied within hedge funds reflect this and are structured to ensure that the manager&#39s interests are alig-ned to those of the investors. In addition to a fee based on the starting capital of the fund, hedge funds also levy a performance-related fee of about 20 per cent if a performance target is met and any previous losses have been made good.

Hedge fund managers are further incentivised by being expected to invest some of their own wealth into the fund. This reinforces the alignment of manager and investor interests.

Hedge funds are not required to pay out income received during the accounting period and generally accumulate income.

US hedge funds are taxed at the partner level whereas offshore hedge funds are usually only subject to withholding taxes internally. As most offshore funds have non-distributor status, UK resident investors are potentially subject to income tax both on repatriated income and gains, unless sheltered via an SSAS, Sipp or offshore life bond.

To maximise the manager&#39s investment freedom, most hedge funds impose an initial lock-in period of between one and three years before investors may deal in the hedge fund&#39s shares. Any dealing that subsequently takes place is then usually only permitted at the end of each month or quarter.

It may come a surprise to learn that as there is no universal definition of hedge funds. While many textbooks refer to four broad strategies or fund types – long/short equity, market-neutral, event-driven and global macro – others cover more than 30 strategies.

However, each of these approaches can be broadly segregated into non-directional, and directional strategies, which generally translate into lower and higher-risk fund strategies. While both focus on producing positive absolute returns, the former seek to contain losses and reduce volatility by insulating manager skill from broad market movements whereas the latter typically employ high levels of gearing without hedging to reinforce a directional view on markets.

The most common lower-risk strategy is that of long/ short equity. As intimated earlier, this is the original hedge fund concept of going long and shorting individual securities, or equity derivatives, and accounts for nearly 50 per cent of all hedge fund investment by value. Also known as equity-hedged, superior absolute performance derives from astute stock selection and market timing.

The other non-directional strategies are more specialist and are driven by the exploitation of pricing anomalies. Generically, they are known as relative value strategies and are detailed below.

Individual stock selection rather than directional market moves also drives this refined long/short equity strategy, commonly known as statistical arbitrage. By concentrating on those companies whose share prices have typically traded in a narrow range but have since diverged, a long/short strategy is adopted in the expectation that the prices will revert to trading within this range.

Companies occasionally issue convertible loan stocks that start life as interest-bearing securities but which can be converted into the company&#39s equity at a fixed future price on or between fixed future date(s).

If a pricing anomaly between the convertible and the company&#39s equity arises, this can be exploited through a specialist low-risk long/short strategy. However, since these pricing differences are usually very small, a considerable sum of money needs to be devoted to each trade for this strategy to be profitable.

This strategy exploits the pricing anomalies between similar fixed interest securities and related derivative instruments through geared long and short positions. By picking up small arbitrage gains, fixed income arbitrage aims to produce returns marginally above that available from investment in short-dated bonds.

This specialist strategy focuses on anticipated company events.

In the event of a takeover bid, a long position is taken in the shares of the target company while the predator&#39s shares are shorted. Necessarily, the success of the bid, or the associated deal risk, rather than the direction the broader market takes, determines performance as many such funds found to their cost when the GE/Honeywell merger failed to come off last year.

Restricted to the US market, distressed securities hedge funds purchase the securities issued by companies afforded protection under Chapter 11, if they believe the company can successfully reorganise itself. These securities typically trade at a significant discount to their nominal value owing to regulated funds being prohibited from taking a position in these assets.

Higher-risk strategies include:

•Global macro

Once synonymous with hedge fund investing but now only accounting for about 15 per cent of hedge funds by value, this top down market directional strategy was typified by George Soros in running his Quantum fund. Global macro funds, through geared long and short positions, speculate on the outcome of specific macroeconomic events, such as the sustainability of exchange rate pegs and price movements on world markets.

•Short selling

Understandably unpopular in bull markets, this strategy entails being at least 50 per cent short of the equity market through the use of equities or equity derivatives.

•Emerging markets

Given restrictions in many emerging markets on short selling and the lack of derivative instruments with which to hedge, emerging markets hedge funds are not usually all that different from conventional emerging market investment funds.

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