This is a far cry from five years ago when a hedge fund called Long Term Capital Management was unable to cover its leveraged positions, leading to a $3.5bn bail-out put together by the world’s largest financial institutions under the direction of financial authorities across Europe and North America. Expertise in hedge funds has improved considerably since and, consequently, the public perception of these funds has improved correspondingly.
Opportunities
In its rawest form, a hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously, with many hedging against downturns in the markets — especially relevant in today’s markets with volatility prevalent.
The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.
Hedge fund styles vary enormously. Broadly speaking, there are 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return.
And for the intermediary and the final client, it is important to understand these differences, as they trigger a big difference between investment returns, volatility and risk among the different hedge fund styles. This is a pre-requisite to successful investment in hedge funds.
Pulling power
The primary aim of most hedge funds is to reduce volatility and risk, not to increase volatility as many people think. Few hedge funds use complicated derivative structures, and when they do, this is for hedging reasons. Most do not use derivatives at all, and many use no leverage.
Hedge funds have grown in popularity largely because investors have wised up to their benefits and have become increasingly convinced of their robustness.
There are several factors which have particularly appealed to private clients:
Non-correlation
The wide range of hedging strategies available to the fund managers makes them even more attractive for investors looking for diversification and absolute returns, Many of the strategies used by hedge funds will benefit from one key overriding factor: their non-correlation to the direction of equity or bond markets.
The most plain vanilla hedge fund investment style is short-selling. This involves selling securities short in anticipation of being able to re-buy them at a future date at a lower price due to the manager’s assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments.
Less volatile investment strategies might include a market neutral equity: these funds attempt to hedge against systematic risk by going long and short securities in the same sector, market capitalisation or country. Market neutral funds sell short instruments that they expect to underperform, buy instruments (often in the same sector) that they expect to outperform, and invest the proceeds in their “cash” portfolio. Statistical effective analysis and stock-picking are essential to obtaining meaningful results for any manager specialising in this style.
A convertible arbitrage strategy attempts to hedge out most market risk by taking offsetting positions. For example, the hedge fund manager might buy a long position in a firm’s convertible bonds but go short in the underlying issuer’s equity. Fixed income strategies also have low volatility and usually invest in bonds and sometimes fixed income derivatives to profit from principal appreciation and interest income.
Distressed style
Global macro hedge funds aim to profit from changes in global economies typically brought about by shifts in government policy that impact interest rates, which affect currency, stock, and bond markets. As their name indicates, they are able to invest worldwide.
A distressed securities hedge fund style might be a little more volatile, but provide greater returns. This style buys equity, debt, or trade claims at deep discount of companies in or facing bankruptcy or reorganisation. Distressed securities hedge fund managers benefit from the market’s lack of understanding of the true value of the deeply discounted securities and the inability of institutional investors able to invest in below investment grade securities.
More aggressive hedge fund strategies might include emerging markets hedge funds, which invest in equity or debt of emerging markets that tend to have higher inflation and volatile growth than a developed economy.
Normally, such funds use leverage and derivatives to accentuate the impact of market moves. Aggressive growth strategies invest in equities expected to experience acceleration in growth of earnings per share.
Techniques
Managers managing hedge funds will use various techniques to optimise returns. These include quantitative, model driven and security selection. Employing the right management technique is essential in running a successful hedge fund business — many firms have had problems in this area in the past.
Hedge funds provide entry levels for all types of investors. A fund of hedge funds is the most appropriate “ground floor” level at which the inexperienced investor can enter. Fund of funds products invest in multi-strategies, using multi-managers; so such a fund might invest in all 14 styles, using up to 30 managers. Fund of funds seek to deliver more consistent returns than stock portfolios, mutual funds, or individual hedge funds.
An investor in a fund of funds product would typically be looking at an 8 to 10 per cent annual return, with a reduced volatility of only 4 to 6 per cent.
Beyond the most obvious benefits of fund of funds products, they also eliminate the need for time-consuming due diligence required for single hedge fund investments. They allow for easier administration of widely diversified investments across a large variety of hedge funds. They also allow access to leading hedge funds that may otherwise be unavailable due to high minimum investment requirements.
For this product, BNP PAM has 25 analysts in their London office, who monitor the performance of the hedge funds and the managers who manage them. We periodically fire and hire new managers to ensure our investors get the best fund of funds product.
For the investor with greater knowledge of hedge funds, a multi-manager strategy might be more appropriate. This gives the investor the opportunity to choose a style they like, or what might be popular at the time, but smooth off some of the risk by distributing it between different managers.
Those investors, usually ultra-high net worth individuals or family offices, wanting to take a single strategy can do so, but this should be done only with balanced portfolio investment criteria in place.
Popular strategies in the first half of 2003 were long-short investments, whereas much of 2002 was dominated by global macro strategies.
Slight changes in political or economic conditions can ensure one hedge fund style gains at the expense of another. The important thing is to have access to the expertise that can take advantage of these moves as quickly as possible.
Francois Hullo, managing director, alternative investments, BNP Paribas Asset Management
