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On the hedge of a new world

Fund advertisements constantly remind us that the long-term trend of share prices is to rise over time.

In bull markets, advisers just need to keep clients fully invested and find fund managers that can pick the shares that go up the most.

Conventional investing is rarely challenged in normal conditions but two years of no progress in major stockmarkets can seem like a long time to investors.

Now advisers are suddenly wakening up to the potential of absolute return hedge funds. Not least of their plus points for IFAs is their potential to retain clients in difficult times.

Lower inflation than in previous decades will result in lower equity market returns. This stockmarket pattern – with little overall trend but a lot of volatility in individual share prices – seems ideally suited to a hedge fund approach.

With share prices going up and down and financial instruments available to allow profit to be made in either direction, it seems sensible to pick funds and managers that can do both. The challenge for advisers is to do this without significantly increasing risks for clients.

The first thing that advisers realise on looking more closely is that hedge funds represent an alien world.

Understanding this requires considerable new training, no matter how great an IFA&#39s skill is in traditional investing.

There are barriers, too, in terms of different terminology and techniques.

The tendency for some hedge funds to provide little transparency is also not helpful. The hedge industry thrives on mystique and secrecy.

Fortunately, this is set to change.

The huge potential for hedge investing to grow, if it can enter the investment mainstream, will encourage many managers to acknowledge the demands of conventional investors.

For hedge funds to compete in this broader market, they will need to give additional reassurance to IFAs.

Management groups will also need to offer lower-risk entry into the world of hedge investing through vehicles such as funds of hedge funds. These developments make it a good time for IFAs to begin their research into this area.

The last two years have been good for most established hedge funds, with many also achieving lower than average volatility.

Current conditions – with major telecoms and technology shares falling dramatically – are tailor-made for funds that can sell short. They can profit from shares going down, when inertia in conventional funds or closet indexing styles, can make traditional managers react only slowly to company disappointments.

However, IFAs should be warned that it does take experience to be able to get short selling right consistently. With higher portfolio activity rates in hedge funds – aiming to reduce risk by more frequent investment decisions — good management of short positions requires experience.

In addition to stock selection, trading and risk control are also important. Successful hedge fund management involves juggling many more variables than long-only funds, and advisers must learn new techniques to pick the managers that are good at this.

Some of the stars of the hedge industry are not familiar names. Equally, some household names of traditional investing are viewed as novices by hedge specialists.

Long/short equity funds that focus on Europe and the UK have been a rapid area of growth in recent years. Many familiar names have recently entered this space and that has encouraged new investors. It is also clear that within established groups, star managers are gravitating towards hedge funds and there have been some high-profile departures of managers to set up boutiques specialising in long/short investing.

Although major brand names offer the comfort of familiarity, there can be risks in trying to reconcile traditional and hedge investing within a single group. There are tensions in terms of reward structures, research and dealing. Smaller specialist hedge boutiques that focus entirely on hedge or have been able to balance the two areas over many years, are worth considering.

Advisers should not try to analyse hedge funds using traditional approaches. In studying this area, they will need to learn new tools. Even traditional risk measures, such as standard deviation or volatility, do not adequately capture the characteristics of hedge funds. Terms such as drawdown, percentage performing months and Sortino ratio will need to be understood.

Fortunately, there are some good websites such as hedgeworld.com and the Hedge Fund Association&#39s site thehfa.org that offer good background information. This includes definitions, performance data and articles.

Given the risks of entering a new area, advisers are likely to focus initially on funds of hedge funds. These will probably be the best entry point for private investors. A key issue in this type of fund is identifying correlations between managers to enhance the overall characteristics of the portfolio. Fofs diversify across a number of managers and should research those managers in detail.

Despite difficult stockmarkets, hedge funds and the new funds of funds that are appearing are a powerful tool for advisers.

Recommended

Man Group – Man Alternative Investments

Thursday, 15th March 2001.Type: Investment trust.Aim: Growth by investing in hedge funds.Minimum investment: £100,000.Maximum investment: None.Investment split: 100 per cent in hedge funds.Types of share: Ordinary.Isa link: No.Pep transfers: No.Redemption date: None.Charges: Initial up to 2 per cent, annual 1.25 per cent.Commission: None.Tel: 020 7285 2000. 

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