What is a Hedge Fund?

For most investors, the high-finance world of hedge funds is still shrouded in mystery. This is because they are only open to a limited range of investors, and they are registered offshore for tax purposes, making them very difficult for most investors to access. However, their innovative investment strategies are becoming increasingly popular, with many of their strategies becoming widely adopted by mainstream fund managers. So how do hedge funds make money? Here’s a summary of the main points.

The Demand For ‘Absolute’ Returns

Hedge funds aim to generate returns far greater than those that could be achieved by a traditional ‘long only’ fund manager. A traditional fund manager uses an index of stocks (such as the FTSE All Share) as a benchmark, and aims to generate relative returns that are ahead of the index. For example, if the FTSE generated a return of 8% last year, a fund manager whose portfolio achieves a return of 9% will have outperformed his benchmark.

Hedge fund managers take a different approach. They don’t measure themselves against a benchmark. Instead they look to achieve ‘absolute returns’, which in theory means a return greater than zero, but in practice means that they can achieve a great deal more.

Imagine that the FTSE falls by 12% this year. Over the same period your portfolio of stocks has made a return of -10%. You could claim that you have portfolio has ‘outperformed the benchmark’, and you would be right. But in real terms, your investment has lost money.

Hedge funds sell themselves to wealthy clients because they claim that superior fund manager skill will allow them to create a positive return regardless of the market conditions, and without sharing the same performance characteristics of an index. To achieve this, hedge funds use a number of different strategies to generate additional returns.

• Long/short: Hedge fund managers buy stocks they believe will rise in value, but they can also short (sell stock that they do not own) if they believe that the price of a particular stock will fall. Once the stock price has fallen, the manager will make a profit on the re-purchase of that stock at the lower price. Hedge funds often borrow money to finance these trades, which can increase the risk involved.
• Relative value: Managers can compare two separate assets to determine the ‘fair value’ of both. Profits can be made by buying cheap assets and shorting the expensive ones.
• Event driven: A particular favourite of hedge fund managers. The aim is to buy shares in a company that will be taken over or merged into another company. Once the merger takes place the values in these stocks increase dramatically. These are extremely high-risk investment because mergers that are often rumoured to happen never do. The activities of companies are often unpredictable.
• Trading strategies: taking investment positions in the performance and direction of markets, currencies or commodities such as oil.

Performance Fees

One of the defining characteristics of the hedge fund industry is its emphasis on performance fees. These fees give a large share of the fund’s positive returns back to the manager. Why do investors agree to this? Because they are happy to pay managers generously when they are generating big profits. A manager with a good reputation could charge more than 20% of the fund’s returns in performance fees. However, many believe that such high fees encourage managers to take short-term risks at the expense of long-term returns.

The Pitfalls of Hedge Fund Investing

Hedge fund managers are very skilful, and they can generate a lot of money for their clients. However they can still lose money, or generate returns below expectations. The investment techniques they use are often considered more risky than those used by traditional savings vehicles. For example, if you short a stock on the believe that the price will fall, you could suffer substantial losses if the price goes up.

Some hedge funds have also been accused of distorting the market. The Financial Services Authority suspended the short selling of financial stocks earlier in 2008, when it suspected that short-sellers were exploiting the weakness in HBOS shares to drive the company towards bankruptcy, and in doing so making massive profits. Nothing was proven, but the FSA felt is necessary to take steps to prevent short sellers from driving the share price of a company to the point of collapse.

Because of their mysterious and exclusive nature, hedge funds will continue to be something of a mystery for most investors. Despite their notoriety, in a market where positive performance will be increasingly hard to come by, the hedge fund approach will continue to be popular with wealthy investors looking to maximise their savings, as long as they understand the associated risks.