Hedge funds 101: What’s the difference?

Despite market conditions being right for hedge funds to flourish in, it is still some time off before retail investors and their financial advisers flock to them like ducks to water.

One would expect that hedge funds, especially those that are ‘absolute return’ styled vehicles, would be the flavour of the month at a time where investors are being burnt by low single returns.

But perhaps it’s more a case of hedge funds in their current guise not having been around for long enough to be noticed before things started to go pear-shaped around April 2000. And it could also be a case of fear of the unknown.

Absolute Capital’s head of distribution Joshua Goben believes it won’t be until another 18 months to two years before hedge funds arede rigueurin the retail investor’s portfolio.

“Hedge funds’ popularity is certainly on the increase in the retail market, but we still need the appropriate education at the financial planning and investor level,” Goben says.

“While there have been significant inflows, we really haven’t seen a whole lot yet.”

Goben says that ultimately retail investors are absolute return investors by nature; they prefer to see their savings grow in bad times rather than be dragged down into the negatives because of what’s happening in overseas and local markets.

For this reason, Goben believes that the more savvy investors and planners who understand the niche that hedge funds fill and the role they play in nullifying risk, gravitate towards a fund of hedge funds style product when testing the waters.

“Fund of hedge funds allow the investor to outsource the responsibility for investing to the fund of hedge fund manager which constructs the portfolio of hedge funds for you. This also allows investors access to those wholesale hedge funds which have minimum investments such as US$2 million,” Goben says.

A glance at the hedge fund line-up in terms of the different styles and strategies could confirm why a fund of hedge funds might be a suitable place to start for retail investors and planners new to these funds. This is because, as investment products go, hedge funds are pretty complex beasts.

There is growing research on hedge funds which usually categorises hedge funds into between three and seven strategies, depending on the criteria used. Hedge Funds of Australia (HFA) recently released a report,Hedge FundsSimplified for AustralianInvestors,which identifies five common styles, as well as some 11 more specialised strategies.

Absolute return hedge funds are all about extracting returns while minimising exposure to volatility at the same time. One way for a hedge fund to minimise exposure to volatility is through a strategy ofmarket neutral investing. A market neutral manager takes on only the exposure to risk of the stock price falling, but does not take on the risk that the whole market, or parts of the market, falls.

This aspect of market neutral investing is one of the least complex strategies of hedge fund management, which is similar to what traditional fund managers do in looking for value in stocks they deem underpriced. But the similarities end there, with hedge fund managers having the ability to take short as well as long positions on stocks.

The market neutral approach aims to balance the stock bought long against that bought short. And as hedge fund proponents will also point out, the manager has twice the opportunity to invest than the traditional manager, since stocks are bought with both long and short positions.

Long and short investing is taken one step further to become a new strategy identified by HFA, that oflong/short investing. Where a market neutral manager would hold a balanced amount of shares bought on long and short positions, the long/short equity manager does so with a bias to a particular position. A manager with a long bias would hold more long positions, while one with a short bias would hold the opposite position.

The hedge fund manager using this sort of strategy takes on a greater risk to market volatility than the market neutral manager, but a more active interest in making profits out of undervalued and overvalued stocks. And if the whole market experiences a quick downturn, the short positioned stocks should mitigate somewhat against losses suffered from the long positions.

Another style of hedge fund investment isevent driven investing. Events with an expected outcome are the key for hedge fund managers employing this style of investment. Such events include mergers and acquisitions, bankruptcies, divestitures, financial restructurings, and lawsuits.

The hedge fund manager here looks not at the company’s overall performance, or strengths, weaknesses or degree to which they are over or undervalued, but rather at how a particular event will impact on the price of its stocks in the short term. The event driven manager will usually take a long and short position, the latter which protects against both the fall in a share price and the market dropping before the event.

The fourth hedge fund strategy HFA presents is that ofarbitrage. Arbitrage traditionally was the purchase of similar stocks in different markets to try and eke out profits from discrepancies of prices. Now it has come to mean investing in similar securities of a company in shares and convertible bonds. A manager might invest long in a convertible bond and short in the company’s shares. This hedges against market volatility, with the trade-off being that gains will be small.

The last style of hedge funds investment in HFA’s list ismacroinvesting. Macro managers are the other end of the risk spectrum to the four above, which all have varying methods to nullify market volatility risk. Macro managers go for high returns, but with high risk. They speculate on global economic events and adopt a position to net the gains from the expected outcome.