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News Bulletin : ADA News Bulletin September 2010
29 SEPTEMBER 2010 Hedge fund managers may invest in the same assets that traditional fund managers use, such as shares and bonds, but may also invest or trade in currencies and commodities. A hedge fund manager also has a broader range of investment strategies to draw on, including the use of short selling and derivatives, to generate absolute returns in a variety of market conditions. This means that hedge funds often differ in characteristics, such as volatility and return, from more traditional investments. THE AUSTRALIAN HEDGE FUND INDUSTRY Hedge funds are not new in Australia, or to Australian investors. However, the industry has experienced significant growth in the last ten years, as demand from Australians for absolute return style investments has accelerated. From government superannuation funds to self managed superannuation funds and individual investors there is a general trend toward increasing the allocation to hedge fund investments. Whereas once hedge funds were dominated by investments from very wealthy individuals, today hedge fund exposure can be found in many investors' direct portfolios, or in the superannuation funds they own. HEDGE FUNDS AND RISK At the height of the GFC the collapse of Bernie Madoff's massive Ponzi scheme and the subsequent media coverage have helped to foster a belief that are all hedge funds are extremely risky. Let's look at some of the myths surrounding hedge funds. MYTH ONE: HEDGE FUNDS ARE EXTREMELY RISKY There is risk inherent in any investment, but the belief that hedge funds are, by definition, more risky than other investments is misplaced. Firstly, there should be a clear distinction between performance risk and operational risk. Regarding performance risk, many hedge funds aim to control risk, not leave it unchecked. By protecting or hedging their portfolios against broad market risks hedge funds can present a lower risk profile than traditional funds. Operational risk (that is, how well a hedge fund operates) is a matter to be assessed in relation to each individual fund. Investing with a reputable investment manager may mitigate this risk. Investors may draw comfort from the fact that the Australian regulatory environment scrutinises hedge funds in the same way as traditional funds. Like any investment, though, you need to be informed before you make an investment decision. You should read the Product Disclosure Statement thoroughly and seek professional fee based advice if you think this could assist your decision. MYTH TWO: HEDGE FUNDS WILL ADD RISK TO MY PORTFOLIO The irony is that while hedge funds have been seen as risky, used wisely they can actually reduce risk in your total investment portfolio. Hedge funds often have a low correlation to traditional asset classes. For example, an equity-market neutral fund may provide a degree of protection during periods of volatile equity markets. Of course, having too much exposure in any investment is risky. If you spread your investments wisely hedge funds can form part of your diversification strategy, helping to strengthen your portfolio and reduce your risk and portfolio volatility. Another factor you need to consider is the effect of 'leverage' (see Myth Four). MYTH THREE: HEDGE FUNDS GENERATE MASSIVE RETURNS Some hedge funds do aim to generate larger returns, but these funds also take on larger risk and can be quite volatile. There is a huge variety of hedge fund investments available, and many of them do not target extremely high returns -- rather, they aim to generate less volatile and more consistent returns than traditional funds. MYTH FOUR: ALL HEDGE FUNDS USE VAST AMOUNTS OF LEVERAGE OR GEARING 'Leverage' or 'gearing' measures the level of financial risk a fund assumes relative to its capital. Leverage or gearing can be achieved by the fund borrowing money to invest. Not all hedge funds use leverage. Funds that use leverage do so to enhance their returns. Some funds use leverage to enhance returns from low-risk trades, while other funds use leverage to increase exposure to directional trades. Leverage is a two-edged sword and funds that use leverage can be more risky than un-leveraged funds. Historically, there have been instances of funds using excessive leverage unwisely and suffering large losses as a result. A hedge fund manager's risk management and leverage use policy is of key importance in assessing the manager for potential inclusion in a portfolio. The important lessons here are to make sure you invest with a reputable manager who has the requisite experience to manage your money. Ensure you invest only in those hedge funds that suit your investment profile and can add diversification and risk- reward benefits to your total investment portfolio. There is a huge variety of hedge fund strategies and an even wider array of investments providing access to hedge funds. For Australian investors, there are four main ways to access hedge funds: • Single strategy funds • Multi-strategy funds • Funds of hedge funds • Structured hedge fund products SINGLE STRATEGY FUNDS Single strategy funds invest directly in financial markets using one main investment strategy. The fund manager has usually developed its skills over many years and has established an 'edge' it believes to be sustainable through a variety of market conditions. An example of a single strategy fund is an Australian equity long/short fund. Single strategy funds usually have high minimum investments and capacity constraints, which limit the size to which the fund can grow. MULTI-STRATEGY FUNDS Multi-strategy funds are similar to single strategy funds in that they invest directly in financial markets. However, the multi- strategy manager uses more than one strategy to generate returns and can usually allocate the fund's capital dynamically in response to the perceived opportunity set for each strategy. The benefit of a multi-strategy fund is that it provides greater diversity to the investor and may offer a reduced risk profile than the single strategy fund. The manager may add new strategies over time, thus helping to prevent capacity constraints. FUNDS OF HEDGE FUNDS For many investors, funds of hedge funds (FOFs) will be their first investment in hedge funds. FOFs do not invest in financial markets directly. Rather they invest in a portfolio of individual single strategy or multi-strategy funds. The benefit of a FOF investment is that the FOF manager uses its expertise to establish and manage a diverse and robust portfolio, and to perform initial and ongoing due diligence on each invested manager. FOF managers usually take a dynamic approach to portfolio management, and switch between strategies and funds as opportunities arise, thereby attempting to ensure a dynamic and efficient use of capital. By pooling investor monies, FOFs are able to access funds that most individuals may not be able to access directly. However, investors in a FOF hedge fund usually face an increased level of fees compared to a single strategy fund investment. investment insight
ADA News Bulletin August 2010
ADA News Bulletin October 2010