The truth about hedge funds

It’s a little known fact that the man considered to be the ‘father of hedge funds’ was born in Melbourne.

Alfred Winslow Jones moved with his parents to the United States when he was four, and in 1949 established an investment fund that ‘hedged’ market risk by selling short some stocks while buying others.

Since then, many of the facts about hedge funds have remained little known, overshadowed by hype and hearsay.

The usual misconceptions — too risky, too expensive, not tax efficient enough — have deterred many from considering an investment strategy that has the potential to deliver positive returns, even when share, bond and property markets are falling.

Despite these issues, the popularity of hedge funds has continued to increase. Last year was a record year for hedge fund flows, with $110 billion channelled into the global class in the first nine months of 2006. Currently, there are estimated to be around 9,000 hedge funds in operation (see graphs 1 and 2).

Hedge funds are truly emerging from an obscure corner of the investment universe, held mostly by high-net-worth individual investors, to become a more mainstream choice.

A range of institutional investors, from super funds to not-for-profit organisations and universities, now consider hedge funds an integral part of their portfolios. Volatile markets in recent times have highlighted the benefits of these investments.

BT’s hedge fund partner Grosvenor Capital Management L.P said the demand for hedge fund managers is split into two groups. There continues to be a high level of demand for the finite supply of high quality managers. However, outside of a few high-profile, top tier fund launches, most new manager launches are under-subscribed and experiencing longer funding periods — signals, they believe, of a less frothy capital raising environment.

Here we take a closer look at hedge funds and separate the facts from fiction.

Myth one: All hedge funds are risky

Everyone loves a good story, and most of the well-known stories about hedge funds are those that feature high stakes, high risk and massive gains or losses.

In reality, the risk and return attributes of hedge funds are determined solely by their investment strategy, so hedge fund investments can be low risk — they just don’t grab as many of the headlines as their riskier counterparts.

In the early 1990s, hedge funds built around high-risk global macro strategies made up nearly 75 per cent of the market.

Now, this type of fund makes up around 15 per cent of the market. The empty space has been filled by hedge funds offering a broader risk/return profile and a focus on consistency and protecting investors’ money.

Diversification has also removed a lot of risk and volatility from hedge funds. For example, a fund-of-hedge-fund minimises risk by spreading investments across multiple managers, strategies and asset classes, instead of relying on a single event or prediction. This ‘blending’ aims to provide a more stable long-term investment return than individual funds, and risk and volatility can be controlled by the mix of underlying strategies and funds.

Hedge funds may have been risky once, but the development and growth of the industry has put the decision around risk firmly in the hands of the investor.

Myth two: Hedge funds aren’t tax efficient

Tax efficiency relies on a hedge fund’s classification and investment strategy, so the type of hedge fund you choose is an important consideration if you’re looking for tax deductions from your investment.

Hedge funds that predominantly invest in overseas assets are classified for tax purposes as Foreign Investment Funds (FIF) and are required to distribute capital gains each financial year. Investors pay income tax on these capital gains, whether they are realised or not.

Funds that aren’t classified as FIFs do not need to realise all gains each year, and some returns can be classified as capital growth. In this case, taxpayers may benefit from a capital gains discount.

It is also possible to take advantage of the tax benefits associated with margin lending by financing an investment into a hedge fund entirely with debt, a strategy best suited to hedge funds with low volatility and low risk. Using a margin loan creates the opportunity for tax deductions on the interest cost of a loan, and prepaying the interest on the loan can bring forward any potential tax deductions by up to 12 months.

Myth three: Hedge funds are expensive

Fees for some hedge funds can appear relatively high compared to traditional asset class investments, particularly if the fund charges both a standard fee and a performance fee. But just as all hedge funds don’t share the same level of risk, neither do they charge the same fees. It is possible to find funds offering a transparent fee structure and no performance fees.

Many hedge funds also quote performance returns after fees have been subtracted, which is an important point to remember when you’re comparing the fee/performance trade-off between hedge fund and traditional funds.

Myth four: Hedge funds have capacity constraints

The rapid growth in hedge fund assets has led some industry figures to question whether hedge funds can maintain performance as the number of funds pursuing the same strategy increases.

Grosvenor does not believe the growth in funds under management will have any effect on the returns of hedge fund managers. In fact, growth has allowed an increase in the number of underlying strategies and the number of quality hedge fund managers. This offers an experienced fund-of-hedge-funds manager a wider choice and more opportunities for increased diversification.

A necessary ingredient for portfolios

Hedge funds are alternative investments; they’re designed to give investors an alternative to traditional asset class investments with low correlation to the benchmark performance of shares, bonds and property. When there’s volatility in the market, or little consensus that markets will stay strong or weaken, an investment that generates returns regardless of market direction should be a welcome addition to any portfolio.

Al Clark is head of multi strategies at BT FinancialGroup .