News that the FSA is looking to regulate funds of alternative investment funds has brought to the fore the question of whether financial advisers should consider presenting hedge funds to their clients.
The existence of London-listed closed-ended vehicles has meant that fund of hedge fund-type investments have been available to retail investors for some time. The London-listed sector has grown substantially over the last five years, albeit that many of the investors do not appear to be from the retail arena or always from the UK.
This growth mirrors the situation in European jurisdictions such as France and Switzerland although retail take-up in these countries has been more meaningful.
One of the key questions for a financial adviser is whether they are in a position to understand how to use hedge funds and, indeed, whether they have a potential position in any client portfolios. This article cannot go into the detail of what hedge funds are and the mechanics of the many different strategies utilised but an e-document which explains the use of hedge funds and the underlying strategies is available on request by emailing firstname.lastname@example.org.
However, the rationale for the addition of hedge funds to retail client portfolios is clear and – to myself at least – so is the correct route to follow in gaining hedge fund exposure.
Individual hedge funds can produce high returns but there can also be considerable risks with such an investment which a retail investor is generally not in a position to gauge. It is critical in making most hedge fund investments to carry out intensive due diligence on any fund that is considered for purchase. HSBC has a team of around 15 trained investment professionals for this purpose.
The best route is through a diversified portfolio of hedge funds, probably consisting of at least 20 individual funds. However, the minimum investment into many hedge funds is usually very high, making it hard for a retail investor to build their own portfolio.
Funds of hedge funds provide a simple solution and this is what Faifs will be able to offer. A vehicle of this kind offers diversification as well as access to hedge funds that would not normally be accessible to retail investors.
Why then hold a portfolio of hedge funds? The answer may surprise, especially as our opinion is that such an investment should not normally be considered for the purpose of generating high-octane returns.
A fund of hedge funds is normally targeting returns on an absolute return basis, that is, it does not have an equity or bond-based benchmark. It is fairly typical to see such target returns in the range of cash plus 3 to 6 per cent. Such returns are normally generated with a level of volatility that is around that of a bond portfolio.
There will be years when shares outperform a fund of hedge funds by a considerable amount. However, past history has shown that when stockmarkets go into a prolonged decline, funds of hedge funds are on hand to protect capital and to usually grind out some positive returns.
The rationale for holding a fund of hedge funds is therefore one of diversification. They are usually added to portfolios consisting of shares or bonds or most likely both of these.
If one looks at why institutional investors tend to hold hedge funds, according to last year’s Casey Quirk and Aceto survey, the main reason was a belief that traditional investment returns from equities and especially bonds were falling versus historic returns and that funds of hedge funds could provide diversification and absolute returns with the level of volatility expected from bonds.
Thus, within the bond component of a portfolio, a fund of hedge funds should generate outperformance for about the same level of volatility. For the share component, they should provide a degree of downside protection in a bear market phase. These characteristics should also prove attractive to retail investors.
There are still some doubts about how Faifs are going to work as well as how they will be taxed. Until these issues are resolved, it would be premature to speculate on how much take-up there is likely to be for funds of hedge funds by retail investors in the UK.
Their potential addition to the retail environment follows developments in many other countries. If they are used for the purposes I have suggested above, even if these may seem a little mundane versus the media hype often found surrounding hedge funds, they should prove to be a successful new addition to the financial adviser’s toolkit.
Jamie Murray is head of institutional business development and distribution at HSBC Alternative Investments.