Personal Finance: The Allure of Hedge Funds

Article excerpt

Byline: Trevor Law

Even the best can get it wrong. In the volatile world of investments, hedge funds have enjoyed some spectacular results but never forget there is no such thing as an investment that cannot fail.

In 1994 in the USA, the celebrated Salomon Brothers bond trader John Meriwether assembled an all-star cast of academics and traders to run a new hedge fund called Long-Term Capital Management.

High flying investors, including large investment banks, put $1.3 billion dollars into the fund trusting in the analytical prowess of academics and the market expertise of traders.

By 1998, large amounts of investors' capital had been lost and the Federal Reserve put together a $3.5 billion rescue operation to prevent a crisis turning into a default disaster with global implications.

Nevertheless hedge funds with their ability to produce dramatic returns have retained their popularity with high net worth investors. They are hardly a new phenomena.

In 1949, Alfred Winslow Jones, a reporter with Fortune magazine, started an investment partnership in America that is regarded as the first hedge fund.

He believed investors could get higher return using hedging through short-selling and leverage methods in an investment strategy rather than taking the orthodox long-term approach. From 1962-1966, Jones outperformed the leading mutual funds by more than 85 per cent, net of fees.

This startling performance sparked a wave of interest in hedge funds. By 1968, there were approximately 200 American hedge fund managers and despite a (large) stutter in 1998 due to the LTCM crisis, by the middle of 2004 there were over 7,000 funds in existence worldwide with $866 billion under management.

This may sound significant but the investment bank Merrill Lynch estimates that hedge funds account for just 1.5 per cent of global assets

What is a hedge fund? There is no simple, all-encompassing definition but a hedge fund can be described as an actively managed vehicle with a flexible investment policy implimenting a diverse range of strategies.

It tends to share the following characteristics - absolute returns, skill-based strategies, flexibility, diversity, alignment of interest and performance-linked remuneration for managers.

The quest for absolute returns is one of the major differences to mutual funds - and one of the most attractive features for investors especially taking the equity bear market period of 2000-2002 into consideration.

Most mutual funds invest in a predefined style, such as 'large cap growth' or into a specific sector such as technology. If you buy a 'large cap growth' fund and the FTSE Index falls by 20 per cent, the fund manager would regard it a success if his fund is down by 15 per cent. This scenario occurred often in the recent bear period but is hardly much consolation to investors when they experienced such real drops in their portfolios.

Hedge funds on the other hand seek positive absolute returns, regardless of the performance of an index or sector benchmark.

The activeness of hedge funds explains their popularity. In the most recent bear market, many achieved absolute returns while many mutual funds plummeted.

How do hedge fund managers get such high returns? The answer is by employing a diverse and constantly evolving array of trading strategies. These can be grouped into five key style groups - equity hedge, event driven, global macro, managed futures and relative value. …