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Life on the hedge

Hedge funds were once the preserve of the very wealthy and particularly risk-hungry investor but now mainstream asset management houses are rushing to meet demand from traditional investors for alternative low-risk products.

While it is unlikely that hedge funds will be advertised on the London Underground, organisations such as Bank of Bermuda, Henderson, Schroder and HSBC have either set up or are in the process of setting up alternative vehicles offering low volatility and absolute returns.

Demand is being driven by recognition of the historically superior risk-adjusted performance achieved by the majority of hedge funds which follow such styles. The result is an industry which is estima-ted to be growing at between 20 and 25 per cent annually with around $385bn in assets worldwide and which is expected to reach £1trillion in the next few years.

A number of high-profile pension funds are among those raising their exposure to this asset class with, for example, Nestle&#39s $4.1bn Swiss pension fund allocating 6 per cent to hedge funds.

The characteristics of hedge funds as an asset class include strategies other than traditional long-only investment, an emphasis on absolute returns rather than comparison with any benchmark and some form of performance-related fee structure. A follow-on factor from the aversion to losing money in any period, including in market downturns, is a risk control process designed to reduce the volatility of returns.

Hedge funds are often perceived as utilising high levels of leverage but only a handful of managers follow this route and many will typically have a net exposure to the market of less than 100 per cent.

The range of strategies available to managers is extremely wide, with many employing niche or specialised techniques. The foremost are as follows:

Long/short equity hedge

This is perhaps the most traditional strategy, with managers buying undervalued securities and short selling those they consider overvalued. Exposure on both the long and short side can be varied so that funds can opt for either a market-directional or market-neutral bias.

Global macro

This is the strategy for which the likes of George Soros became known and can be summarised as taking large, opportunistic and generally lever-aged bets on major macroeconomic events, for example, interest rate or currency movements worldwide. Returns can be spectacular but these are more than amply reflected in associated levels of volatility.

Market neutral

These include a broad range of sub-strategies but are generally characterised by consistent returns with low volatility. Often they have an absolute target of between 10 and 15 per cent year-on-year and tend not to be dependent on the direction of financial markets.

Also known as relative value, these incorporate merger or convertible bond arbitrage, mortgage-backed securities or futures and options strategies.

Event driven

These invest in announced corporate takeovers and similar corporate restructuring.

Distressed securities

These focus on the purchase of securities of companies in reorganisation – usually their debt – and often the active participation by the hedge fund manager in the reorganisation process itself.

Short selling

Consists of the sale of borrowed securities considered overvalued in anticipation of repurchasing them for a profit at lower prices.

One of the drivers of the change in philosophy for hedge funds is the fact that the bull run of the past few years has not necessarily been a comfortable ride, characterised by increased volatility and often very narrow markets. Indeed, much of the rise in the S&P 500 index can be attributed to as few as a dozen stocks.

Meanwhile, as global markets come to terms with a rising interest rate environment and the apparent end (for now) of the boom in technology, media and telecoms, investors are looking for ways to protect their gains.

Hedge funds have come to be seen as a fourth asset class, providing additional diversification and the reassurance that historically they have offered a significant level of capital protection in falling markets.

Managers must be evaluated both quantitatively and qualitatively since selection is crucial to performance. However, lack of transparency, particularly compared with mutual funds, can prove difficult for investors. Other factors that investors must moni-tor include the risk management process, the degree of liquidity and leverage in a fund and personnel risk and asset growth risk.

The level of required due diligence is not only greater but also continuous with regular contact and onsite visits made to managers. The complexity of the monitoring process is such that many investors are turning to funds of funds where this process is undertaken by banks or investment management houses which have the necessary expertise.

Fund-of-fund and multi-manager structures have many advantages. They incorporate in a single portfolio a number of hedge fund managers and can focus on a single strategy or diversify across a variety. The mix is determined by a fund&#39s desired level of return and acceptable risk parameters.

Funds of funds can be accessed for as little as $10,000 which is much less than the majority of single-manager hedge funds which traditionally have minimum subscriptions of anywhere between $500,000 and $10m.

Investors in a fund of funds can receive consistent results with reduced volatility as well as a reduction in the possib-ility of total capital loss. If the performance of a single manager falls off, investors are insulated by virtue of diver-sification. Added to this is the fact that return streams can be structured so as to be non-correlated with equity or bond markets.

Funds of funds overcome the issue of closure since they are already invested and simply raise or lower their existing allocation.

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