Hedge funds have often been characterized as high-risk investments, but such generalizations are neither warranted nor helpful. In the current climate, investors need to be informed about the full range of investment opportunities they can consider.
An increasing number of investors are becoming convinced of the valuable diversification benefits and strong risk-adjusted performance that hedge funds can offer. The attractions of hedge funds have recently come under the spotlight because of the way in which they have preserved, and in many instances grown, capital since the onset of the equity bear market in 2000.
The combination of strong performance, increased accessibility and growing investor awareness of hedge funds has seen industry assets increase significantly. In the past eight years alone, hedge fund assets are estimated to have multiplied more than five-fold.
While much of the new money has come from old sources, more significant is that there have been a number of substantial investments by pension funds. This increased participation by pension funds, the most conservative and largest institutional investors, highlights the growing acceptance of hedge funds by a wider range of investors.
Hedge Funds Offer a Competitive Edge Over Traditional Funds
There have been many attempts to define hedge funds, and most definitions differ in one way or another. However, the hallmark of hedge funds is the pursuit of ‘absolute’ returns — the quest to generate positive returns regardless of whether asset prices are rising or falling. This is a critical difference between hedge funds and traditional funds. While hedge funds seek positive returns through all market environments, traditional ‘long only’ mutual funds typically aim to outperform a benchmark index. Even if asset prices fall, traditional fund managers continue to focus on beating a declining benchmark.
Hedge fund managers are unencumbered by the sort of regulatory and methodological restrictions that characterize traditional fund management. They have the freedom to invest in a range of assets and instruments employing a variety of styles and investment techniques in diverse markets. The ability to use derivatives, arbitrage techniques and, importantly, short selling — selling assets that one does not own in the expectation of buying them back at a lower price – affords hedge fund managers rich possibilities to generate growth in falling, rising and volatile markets.
The skills and actions of hedge fund managers are instrumental to the success of their funds. Instead of relying on a rise in the value of the assets they trade, hedge fund managers apply clear investment processes to exploit market opportunities with identifiable causes and origins. Often these are unusual or niche opportunities that are passed over by the overwhelming majority of conventional investment managers.
Hedge Funds Comprise Diverse Investment Styles and Strategies
While hedge funds do share many characteristics, the range of investment styles used by hedge fund managers is broad. It has become common practice to view the hedge fund industry ‘space’ in terms of styles. As a starting part, styles are a useful way for industry participants and observers to explain what managers do and how they are differentiated. Although there is no definitive view of hedge fund styles, one way to describe the hedge fund industry space is in terms of six main style categories:
Equity Hedge and Long/Short
Equity hedge and long/short strategies comprise the largest style segment in the hedge fund industry. They aim to profit from identifying under and over-valued stocks across a variety of equity markets, and take advantage of the fact that individual shares do not always behave in the same manner or move in the same direction as international stock market indices. Each manager has a particular focus and investment methodology for exploiting profit opportunities. A number of managers employ strategies where long and short exposure is balanced or there are strict parameters for net long or short exposure (equity market neutral and equity hedge strategies), while others utilize strategies with variable exposure or long and short biases (equity long/short strategies)
Arbitrage
Arbitrage strategies are designed to produce positive returns independent of the overall direction of broad market prices. Typically, they exploit pricing anomalies between related securities within and between markets. By establishing long positions in undervalued assets and short positions in overvalued assets, these strategies aim to capture profit opportunities that arise from the changing price relationship between the assets concerned. The most common arbitrage strategies are convertible bond arbitrage and fixed income arbitrage.
Event Driven
Event driven strategies seek to profit from market inefficiencies that may arise out of distressed securities or actual or anticipated corporate events such as mergers, acquisitions, leveraged buy-outs, corporate reorganizations, spin-offs or tender offers. Event driven trading specialist knowledge of special corporate situations as it involves predicting the outcome of particular transactions or situations as well as the optimal time to commit capital to them.
Managed Futures
Managed futures strategies generally employ highly complex computer-driven trading systems to identify and follow trends across a variety of time frames in stock index, fixed income, foreign exchange and commodity markets. They invest on both the long and short side of the market and usually apply quantitative or technical analysis and systematic investment processes.
Global Macro
Global macro strategies are variously referred to as international opportunistic, tactical or directional strategies. They tend to employ top-down analysis of macro-economic and financial conditions to uncover pricing inefficiencies which often arise in countries as a result of political or economic changes at both a regional and national level. Global macro strategies often involve taking large directional positions in securities, interest rates, commodities and currencies within countries or groupings of countries. Asset allocation can be aggressive and this style has been associated with a number of high profile individual managers in the hedge fund industry.
Funds of Funds
Funds of funds are widely regarded as comprising a distinct style group in the hedge fund industry. The fund of funds approach offers investors the advantage of gaining efficient exposure to diverse strategies and the unique skills of different managers through a single vehicle. The value-added role that a fund of funds manager plays often hinges on the manager’s ability to provide access to the capacity of exceptional hedge fund managers that are sometimes closed to investment. Funds of funds managers also have to be expert at conducting due diligence on individual managers, strategy selection, asset allocation and portfolio construction, and risk monitoring.
The Dynamic Evolution of Hedge Funds
Hedge funds have evolved through a process of natural selection — survival of the fittest. In the 1980s and early 1990s, the hedge fund industry was dominated by a small number of so-called global macro hedge funds. Typically headquartered in New York, the most successful of these generated exceptional (if volatile) returns and gathered substantial assets. The managers of these funds employed a variety of investment strategies, but their greatest successes came from executing large trades in G-7 bond or currency markets. Toward the end of the 1990s, the financial environment became less favorable for macro funds and equity hedge and event driven approaches became more popular. Wide divergences between the performance of different stocks and sectors have favored equity-based hedge funds. Event driven investing prospered first with the merger boom, and then with increasing numbers of bankruptcies. Yet the popularity of these strategies is also a result of their conceptually straightforward strategies and relative lack of leverage.
Data collected by Hedge Fund Research (HFR) charts the move away from leverage and complexity toward lower risk and greater simplicity. As hedge fund industry base assets have climbed, most new money has gone to styles like equity hedge and long/short, event driven and convertible bond arbitrage. Meanwhile, the two styles that are most complex and employ greatest leverage — global macro and fixed income arbitrage — have hardly benefited. An increasing number of investors, particularly those who are new to alternative investment, are gaining access to hedge styles by way of fund of hedge fund products. Funds of funds remove the burden of selecting managers and strategies from the investor and place responsibility for these activities on the shoulders of the fund of funds manager.
Hedge Fund Performance Provides the Greatest Justification for Investment
Examination of hedge fund data shows that investment across a spectrum of hedge fund styles would have achieved compelling results over the past decade or so.
Hedge funds offer a source of return that is not dependent upon the appreciation of traditional assets and have the potential to generate positive performance in a variety of market conditions. In that respect, they can offer valuable diversification and improve the risk/reward profile of portfolios with a heavy weighting of traditional stock and bond investments.
(Antoine Massad is associate director and head of Middle East and Asia at Man Investments)
Arab News Business 28 April 2003