Knowledge key to hedging bets

Hedge funds are coming back into fashion. Against a background of poor stock market conditions, which appear set to continue, there is a growing demand for alternative investments where performance is not directly correlated to the ups and downs of the markets.

Several Irish institutions have launched or are preparing to launch, hedge funds aimed at retail investors. Friends First has just launched a fund with a minimum investment of £50,000 (€63,500).

Irish Life is about to launch a fund requiring a minimum investment of £20,000 - it advises that an individual should have no more than 20 per cent of their total portfolio in a hedge fund, so to go into such a fund an investor should have about £100,000 to invest.

There are now estimated to be about 5,000 hedge funds worldwide, controlling about $400 billion (€429,460) in funds. The hedge fund sector is growing rapidly, with banks, investment houses and brokers developing funds to attract retail investors into the market.

In the US, minimum required individual investment levels for participation have fallen from $1 million to $100,000 and are still falling. Traditionally the preserve of wealthy individuals, hedge funds probably first came to public notice when George Soros, investing in currencies and interest rates through his Quantum Group of Funds, generated huge returns for investors.

During its 31-1/2-year history the fund gave its shareholders annual returns of more than 30 per cent. In the five years to the end of May 1998, his Quantum Quota Fund - the best-performing hedge fund - rose by 921.7 per cent on currency bets.

Along with the big successes there have been spectacular failures or near-failures - including Julian Robertson's notorious Tiger funds, and John Meriweather's highly leveraged (borrowed) Long Term Capital Management had to be rescued by a consortium of US banks. And just under a year ago George Soros wound down his involvement in the hedge fund sector after some bad bets on technology stocks. But what are hedge funds and how do they operate? Should they be part of every investor's portfolio and what are the particular risks involved?

A hedge fund buys assets such as commodities, equities, bonds and currencies using investors funds and borrowings, and then "hedges" them against adverse market movements using derivatives or other financial instruments. They are collective investment schemes or limited partnerships often of 100 or less members that offer the prospect of achieving positive returns even when markets are falling.

But they can be very risky investments, with outcomes dependent on the quality and expertise of the fund manager involved. Losses can escalate quickly where a heavily borrowed fund bets the wrong direction and investors can find it difficult to get out if there is a minimum lock-in period and/or set exit times.

A hedge fund manager has a huge amount of flexibility in making and implementing investment strategy. The funds cover a huge range of strategies and different risk/reward profiles, from very conservative funds that attempt to minimise risk within a portfolio to those that actively increase risk by taking highly-leveraged investments.

Some funds offer the potential of huge returns but with a high level of risk. But many of the funds on offer now aim to achieve steady absolute returns with low risk rather than the traditional fund manager approach of beating or matching an index. The danger sometimes is that what appears to be a low-risk strategy can turn out to be high risk in certain circumstances, as happened with the US Long Term Capital Fund, which nearly collapsed when Russia announced it would not pay interest on its foreign debt.

Strategies employed by hedge fund managers include selling short, going long and leveraging to take big positions.

Selling short is a judgment/bet that the price of the asset is going to fall: it involves selling shares/assets they do not yet own at the price now and turning a profit by buying for delivery later when they expect the price to have fallen. Going long is a bet that prices will rise: the hedge fund manager will buy large tranches of shares at today's price if he expects prices to rise, turning a profit by selling later when the price has risen. Often hedge fund managers will borrow heavily against the funds' assets to increase their market exposures.

Other strategies include market-neutral, where long/short positions are balanced; arbitrage macro funds, which speculate on the direction of markets, currencies or commodities; risk arbitrage funds, which typically invest in possible takeover candidates; and niche and sector funds. The real test of hedge fund managers in current volatile and falling market conditions is how good they are at selling short, according to Mr John Lowry of the Geneva and London-based Arundel Partners, which analyses European hedge funds. Managers' expertise at both spotting the stocks that will fall and getting the timing right will be crucial to the sort of returns they can make for investors, he said.

There are similarities between hedge funds and traditional unit funds in that both can be invested in a wide range of assets and can be actively managed.

The main difference is that hedge fund managers aim to achieve absolute rather than relative performance. Where a traditional manager may be happy if his fund falls by 10 per cent against a general market fall of 20 per cent, a hedge fund manager aims to make money in falling markets. The key distinction is that hedge funds seek out investments that are not correlated to the ups and downs of the markets.

Hedge fund managers have a strong incentive to perform well. In addition to annual management charges, hedge fund managers usually get an incentive fee, or a share of the profits they make. For investors the key is to know what the investment manager's strategy and objectives are and to understand those strategies, according to Mr Lowry. "Investing in a hedge fund without knowing both of these factors is a dangerous game," he warns.

International performance statistics compiled by Arundel show that in 2000 the average hedge fund grew by 10 per cent. This compared with a 4.7 per cent fall in the Dow Jones Index and a 39.2 per cent fall on the Nasdaq.

European hedge funds - defined as funds investing in European assets - out-performed the main European stock market indices by 25 per cent to 30 per cent, with returns from different funds varying between 20 per cent and 80 per cent.

The key to this out-performance was not the returns made in the early months of the year when all markets were roaring ahead, but that the hedge funds continued to make money in falling markets by using financial techniques to limit downside risk, according to Mr Lowry.

This was achieved by investing in well chosen inexpensive stocks and carefully shorting some of the most overvalued stocks, mainly at the "exotic end" of the technology sector, he said.

Hedge funds arose out of the theory that there are inefficiencies in the market that can be profitably exploited without incurring excessive risks. The competing traditional efficient markets theory holds that fund managers cannot produce investment returns that consistently outperform the markets over long periods without taking big risks with capital.

An increasing number of European fund managers are investing in hedge funds. A recent survey of 100 top fund managers found that 36 were invested in hedge funds, up from 17 a year earlier. A further 28 planned to go into hedge funds in the foreseeable future. As more institutional investors go into the sector, they are expected to demand more transparency and accountability in a fairly unregulated market.

Single managers have the potential to make huge returns, but they can incur huge losses and single funds can be difficult to get into. But retail investors can invest in a spread of funds to smooth out the return of individual managers - even good managers can have periods of under-performance.

These funds are a combination of different and complementary funds. In most cases there will be additional costs involved in going into this type of fund but risk will be reduced and minimum entry levels will be lower.

Problems with hedge funds have centred on under-performance and fraud. In any growing and fairly unregulated sector some fraud is almost inevitable. Under-performance often occurs when funds grow too large and stray into areas outside their core expertise.

Smaller funds tend to be more nimble and able to move in and out of positions quickly without drawing the attention of the market. The bottom line is that there is money to be made through investing in hedge funds but retail investors should proceed with great caution.