When George Soros, the "man who broke the Bank of England", made the front page of the London Evening Standard on the day that sterling was ejected from the ERM in 1992, the general public got a crash course in hedge funds. The education was extended still further when Long-Term Capital Management, a US hedge fund, nearly brought down the world’s financial system six years later.
The creation of pecuniary envy and lurid headlines aside, what do hedge funds and their managers do, and should you invest in them?
Hedge funds are a post-war phenomenon. The story starts in 1947. Alfred Jones, a sociologist and sometime financial journalist, hit on the idea that his investment returns could improve by not just buying cheap stocks, but also by simultaneously short selling expensive ones.
If this strategy — now called long/short equity — works to perfection, the expensive stocks go down, the cheap ones appreciate in value, and the entire portfolio is insulated, or "hedged", against market volatility. Jones’s ideas spawned a large industry. Over the years hedge fund investing has developed into a number of different styles. They all have some factors in common.
One is that almost all adopt some form of hedging, either through shorting stocks, or via the derivatives markets. Another is that they magnify returns through gearing, using borrowing or derivatives.
And hedge fund managers take fat fees, typically a 2% annual management charge and a performance fee of 20% of any profits. Performance fees are often subject to "high-water marks". These mean that the bonus fees are not paid unless the fund performs consistently well.
Many ways to make a buck in hedge fund land...
As well as the classic "long/short equity" style invented by Jones, there are several other hedge fund strategies. Market-neutral, or "relative value" funds, for example, buy and sell a range of investments (typically bonds or shares) but are not dependent on the movement in the market to generate their return. They mainly use timehonoured techniques of arbitrage to get their returns, which are then magnified by leverage.
So-called "event-driven" funds also pursue strategies largely unaffected by the direction of the markets in which they operate. Instead they rely on a trigger, usually a takeover or a bankruptcy, to produce the return. In each case the hedge fund manager will use in-depth analysis to analyse where any anomalies might occur and seek to profit from them. Merger, or "risk arbitrage", funds normally try and profit by buying shares in the target and shorting the shares in the bidder, build a big position, and agitate for a higher takeover price.
"Global macro" funds, the Soros-style of fund, either use a computer-generated system to generate their trades — or simply fly by the seat of their pants. On occasion some funds are doing little more than backing hunches. They are making large leveraged bets, often unhedged. Returns can be big, but volatile. Other styles include: dedicated short-selling funds, emerging market funds and multi-strategy funds, which employ a mix of styles.
In pursuit of "alpha"
What all of the hedge fund strategies have in common, and the underlying rationale for investing in hedge funds, is the search for absolute returns. This is sometimes called "alpha". "Alpha" is the extra return a skilled manager can produce over and above the market return (or "beta"). Whereas many conventional fund managers aim simply to outperform their chosen benchmark index, hedge fund managers seek to produce positive gains in all market conditions.
The table on page 5 shows how a spectrum of hedge fund styles has performed over various timescales. Hedgeindex has compiled this index over many years, and although it has its imperfections, it remains the best general proxy for hedge fund performance that we have.
How to buy a hedge fund
So can you, and should you, invest in them? And, if so, how?
It depends on how much you want to invest. Any investment advisor would suggest that hedge funds should only form a minor part of your portfolio and even then only at certain points in the market cycle.
There is no point buying a hedge fund in the middle of a roaring bull market. But with the current bull run in equities starting to look long in the tooth, now could be the time to consider them.
RETURNS FROM DIFFERENT HEDGE FUND STYLES
| Return in percentages | |||
| YTD | 1 year | Average since 1994 (% p.a.) | |
| Overall | 11.8 | 13.6 | 10.9 |
| Conv. arbitrage | 12.6 | 13.7 | 9.0 |
| Short selling | -7.2 | -9.0 | -2.6 |
| Emerging markets | 17.2 | 20.0 | 9.1 |
| Equity market neutral | 10.2 | 11.8 | 10.0 |
| Distressed securities | 13.7 | 15.6 | 13.6 |
| Merger arbitrage | 7.6 | 8.5 | 7.8 |
| Fixed income arb. | 7.9 | 8.4 | 6.4 |
| Global macro | 12.0 | 13.8 | 13.5 |
| Long/short equity | 12.1 | 15.2 | 12.0 |
| Managed futures | 3.9 | 1.2 | 6.2 |
| Multistrategy | 12.5 | 14.7 | 9.7 |
| Source: CSFB/Tremont Hedgeindex | |||
The problem is that conventional hedge fund investment requires a high minimum investment, as much as $250,000 or $500,000 in some cases, which rules them out of court for most investors. This is particularly so if you only want hedge funds to represent, say, 10% of your overall portfolio, and want to invest in several to get good diversification. Not only that, but many of the best funds are closed to new investors.
Hedge funds are usually tight-lipped about their investment strategies, and investors are also often locked in for a lengthy minimum period and after that may only be able to cash in their investment at specific times and under certain pre-set conditions.
This means it is hard for ordinary investors to get all the information they need to make a decision on which funds are right for them.
But there are other ways to access absolute return investing strategies. These take three forms.
1. Funds of Funds: Typical minimum £10,000 — £15,000; some listed offshore
Funds like this invest in a spread of individual hedge funds. Though they charge management fees on top of the performance fees that the funds they invest in also levy, they carry significant advantages for investors.
Most important is that fund of funds groups have employees who analyse and monitor the performance of individual funds. They also tend to have priority access to some of the better funds that might be closed to individual investors.
A variety of styles are available, but funds like this share some of the liquidity constraints of individual hedge funds. Many have 90-day notice periods before units can be redeemed, for example.
Open-ended hedge funds of funds — rather like unit trusts in construction — typically have an offshore domicile and are not regulated under the Financial Services & Markets Act.
This means that fund groups cannot market them actively. So private investors who want to buy funds like this have to do so through a qualified intermediary.
They have to demonstrate that they are wealthy enough to be able to stand the capital losses that might come with them, and that they understand the risks. In practice, this has meant that investors in funds like this tend to be wealthy individuals, even though some funds have comparatively low minimum investment amounts.
In addition, realised gains by the individual investing in funds of this type are subject to income tax rather than CGT. The exception to this rule is if the funds are used in a SIPP, in which case the gains accrue tax-free.
The quirks of this type of fund of fund investing have led many investors down the closed-end fund route. Several investment trust-style hedge fund of funds have been launched in recent years. Funds have been launched by big names like Goldman Sachs, Deutsche Bank, and HSBC, as well as by some smaller specialist fund groups.
2. Closed-end hedge funds: No minimum investment; listed
There are now more than 20 regulated and listed closed-end funds — rather like investment trusts operating in a hedge fund style — on the London market with an aggregate market value of around £3bn. Some funds focus on investing in established, well-known funds: others have much more exposure to newer managers. Most funds are denominated in dollars. Some hedge currency risk: others don’t.
The big issue with closed-end funds is the possibility that the share price will not reflect the movement in underlying net asset value (NAV). Some funds have set up sophisticated mechanisms to make sure that discounts that do open up can be narrowed through arbitrage. Most take the form of automatic authority to buy back a certain percentage of shares at NAV if a discount in excess of 5% opens up, although this isn’t an infallible solution as a fund’s firepower in this area can quickly get used up.
Even so, given the way hedge funds work, performance over the last few years has been muted, certainly relative to the gains seen in equities. Dexion Absolute, one of the largest funds and a constituent of the FTSE 250, has seen its share price rise 32% over three years versus a gain in the All-Share of almost double that amount.
The table below shows the current exchange traded hedge fund of funds listed in London that have a market value of £100m or more.
3. Hedge fund ETFs: No minimum investment; listed
A neat solution to the problem of fund choice, costs and complications has recently opened up in the form of the New Star Hedge ETS hedge fund tracker. This tracks the RBC Hedge 250 index, a recently created index of 250 of the most prominent individual hedge funds, including some that are closed to new money, and should, in theory, provide a proxy for hedge fund returns.
As a listed exchange traded fund, dealing costs are low and there is no minimum investment required.
The share can be dealt in the normal way through a broker and has the ticker symbol HXS. A stock is also listed that produces three times the index return (ticker symbol H3XS). There are also $ and € versions. Goldman Sachs reportedly has a similar product in the course of preparation.
Action to take: Decide if hedge fund investing is really right for you. Review the portion of your portfolio you wish to devote to them. From this, bearing in mind the minimum investment levels and tax exposure required, select from the options described above. Don’t expect too much. You should expect slow but steady positive returns, uncorrelated with the stock market.
