Hedging your bets with the right fund

While hedge funds and managed futures have been in existence for decades, it is only recently that growth has taken off in the US and Europe. Rick D Bernie believes there are signs the market is poised for expansion in Australia.

Hedge funds - high risk or high return

Institutions and sophisticated investors are increasingly seeking alternatives to conventional investment strategies. At the same time, hedge funds are increasingly being accepted as an approach to trading numerous markets using sophisticated techniques.

Hedge funds are basically private investment partnerships which can participate in practically any market from currency, financial futures and derivatives to conventional stocks and bonds.

Unlike typical unit trust fund managers, who are highly regulated and often participate in similar strategies in limited markets, hedge funds are often lightly regulated and have a number of important tools at their disposal. They can also go long or short, and use varying degrees of leverage.

Apart from running trading strategies that differ from traditional portfolios, hedge fund managers are also distinguished by the fact that they add considerable value above and beyond the performance of the underlying market sector.

Managed futures funds are a close relative and are often included in a hedge fund grouping.

Broadly speaking, managed futures are an investment for the purpose of speculating in futures and options markets. The term managed futures represents an industry comprised of commodity trading advisors (CTAs). These advisers manage client assets on a discretionary basis, using global futures markets as the main investment medium. In other words, managed futures are simple unit trusts which are allowed to invest in derivative products without necessarily holding the physical assets.

The use of leverage is what has most people misunderstanding the risk of hedge funds and managed futures. While it is true that some use a tremendous amount of leverage, such as Long Term Capital which was geared up about 200 times, there are also funds available that do not borrow money to increase leverage. In fact, many of these funds cannot borrow money and are limited as to how much exposure to futures they may have at any time. The risk profile of these funds is diverse and many are considered lower risk than equities.

Hedge fund investingWhere once futures market traders were limited to hedgers and speculators who attempted to profit from price moves, a new market participant joined the industry in the 1980s; the managed futures investor.

The term "hedging" refers to entering transactions that protect against adverse price movements. A hedge fund could therefore stand for a hedged fund that reduces risk. Unfortunately, the term is misleading, since many hedge funds use strategies that are not hedged or without risk.

Like a speculator, a managed futures investor attempts to profit from price movement.

However, there is a crucial difference. The speculator trades directly while the managed futures investor employs a third-party decision maker to trade on his or her behalf - a commodity trading advisor.

Reasons for growth

Worldwide, hedge funds have grown to more than $200 billion in just a few years. The main growth has come form United States, but Europe and South-East Asia are now quickly catching up.

What has spurred this growth? There are several factors. Individual investors are interested in new global markets as a way to accumulate wealth while diversifying traditional investments and investing in international markets. Futures trading provides a way to benefit from both bull and bear markets, because futures contracts can easily be shorted. In selling short, an adviser attempts to profit from price declines.

The futures markets are leveraged which means a small price movement can have a tremendous impact on trading results. Therefore, it makes more sense to turn the account over to a professional who understands the nuances of the futures market and can increase an individual's chances of success.

Part of the reason for the growth of managed futures lies in the fact that they have delivered returns of more than 15 per cent as a group over the last ten years. Better managers comfortably exceed this. A review of the top 10 global managers shows an average return of more than 20 per cent per year for the last five years - net of all fees.

Controlling risk

It should go without saying that financial planners have the important job of helping clients determine their own risk/reward comfort zone, and further, helping them stay within it. This is especially true with hedge funds, which, while may be considered a high-risk investment, also bring the possibility of high returns.

One way to control the risk of a portfolio's assets is to diversify among different asset classes. Including futures in a traditional portfolio of stocks and bonds provides a way to reduce the total risk of any one investment while potentially increasing portfolio return.

It also opens the door to several other advantages that may not be available in a single investment strategy, including liquidity, global participation and a possible hedge against inflation or a stock market, or bond market decline. In fact, managed futures funds have historically performed best in falling markets.

Successful diversification with managed futures relies on a technical dimension known as the non-correlation of returns. This simply means that different investments produce varying rates of return at different times. Generally, investments within the same portfolio that show low or negative correlation provide the potential for enhanced performance.

According to the late Harvard professor John Lintner: "Judiciously adding managed futures to an existing portfolio of stocks or bonds can actually result in a lower level of risk than if the portfolio were allocated entirely to stocks (or stocks and bonds). Correlation between the returns on futures portfolios and those in the stock and bond portfolios [is] ... surprisingly low, sometimes even negative.

Long term view

The risk/reward of various managers can vary greatly. Planners must also consider the impact the investment cycle will have on the investment. The medium to long-term nature of a hedge fund must be understood before recommending it. Managed futures' potential for loss, as well as dramatic gain, must be accepted honestly, just as equities have positive years and negative years.

The rest of a client's portfolio must also be considered. If you are truly looking for a balanced portfolio, whether it is skewed towards conservatism or more aggressive growth may merely depend on the percentage you allocate to stocks, bonds, managed futures and/or property.

Client suitability

Statistics alone does not solve the question of whether managed futures are right for a particular client. Clients who are frequently interested in managed futures include:

those who have managed equities or a large position in balanced unit trusts;

those with large stock and bond portfolios seeking diversification;

entrepreneurs, franchise owners, and high net worth individuals;

people who understand foreign currencies or commodities;

those who seek higher returns over a longer period;

those who are concerned about falling stock and bond markets

Hedge Funds offer investors the potential for reduced portfolio risk and enhanced investment return. For properly constructed portfolios, managed futures are also shown to offer unique downside risk control along with upside return potential.

Planners should look for a firm with an established reputation and track record that preferably is over five years.

Rick D Bernie is the marketing director with Derivative Fund Management.