| Hedge Funds | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Hedge Funds are fast becoming a popular choice for your investment portfolio, they offer diversification
of your current portfolio that cannot be achieved with the average size portfolio. For as little
as $1,000 it's possible to have access to investment markets that have historically only been
accessed by the rich and very wealthy. New Wealth directions has been protecting clients portfolios for two years now. The inclusion of Hedge Funds in clients portfolios has helped insulate our clients portfolios from the ravages of the recent share market declines on a world wide basis.
"Far from being the high flying speculative funds that attract the interest of the media, most
hedge funds follow moderate investment strategies that rely on the skills of highly qualified
investment managers to achieve attractive risk adjusted returns for investors." The following information is provided by Hedge Funds Australia, we at new Wealth Directions would like to thank Spencer for the use of their material below.
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| An Introduction to Hedge Funds | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Established over 50 years ago, hedge funds are one of the fastest growing asset allocations in the
investment management industry with over 20% p.a. growth fuelling a sector with an estimated A$1
trillion under management and 6,000 funds globally.
The term hedge fund has no legal definition and can be misleading. The term to hedge means "protection against loss" or to "reduce the risk of loss by compensating transactions on the other side". This is a relatively understandable definition however investors should be aware that individual hedge funds vary significantly and not all funds pursue a hedged strategy. A subset of hedge funds called "Absolute Return Funds" are funds that focus on consistently delivering positive returns irrespective of the direction of traditional share and bond markets. They do not manage the portfolios to track a specific index such as the All Ordinaries, Dow Jones, S&P 500, NASDAQ or MSCI. Most hedge funds will incorporate into their investment strategy some degree of this absolute return approach to investing however the majority retain some exposure to market movements. Hedge fund managers can pursue up to 20 different investment strategies that vary in complexity and risk from simple concentrated stock selection to complex convertible bond arbitrage.
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| Hedge Fund Investment Strategies | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Just as the returns and risks vary drastically for traditional investments in shares, bonds and
investment property, hedge fund investment returns and risks vary enormously between hedge fund
strategies. Individual hedge fund managers pursuing a common strategy can vary significantly in
their investment approach (use of leverage, short selling and markets traded) resulting in wide
variations of individual fund investment performances. For inexperienced investors this can
introduce additional risk. For experienced Fund of Hedge Fund managers this represents opportunity
when constructing diversified investment portfolios. This low correlation between managers and
strategies can reduce volatility and enhance returns. Although individual hedge funds differ there
are commonalities amongst hedge funds:
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| Hedge Funds versus Traditional Funds | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Hedge funds have the ability to profit in both rising and falling markets while traditional funds
tend to be handcuffed to the market index they benchmark themselves against. They exhibit a much
lower correlation to market indices than traditional funds with the potential of delivering equity
like returns with bond like volatility.
Combining hedge funds with traditional funds in a well balanced portfolio can lead to an overall reduction in portfolio volatility/risk or enhancement of return or a combination of both. Achievement of the respective objective is largely dependent on the style and type of hedge fund(s) selected for inclusion.
Below we tabulate the key differences between typical hedge funds and traditional funds.
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| Can a hedge fund add value to an investment portfolio? | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Yes -- single strategy hedge funds and Fund of Hedge Funds have a place in most investor portfolios.
They provide strong diversification benefits and can protect investments from market down turns.
The level of exposure depends on an individual investors risk and return profile. It also depends
on what an investor hopes to achieve by using hedge funds. Does the investor want to lower
portfolio volatility or increase overall return or a combination of both?
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| The advantages of hedge funds in periods of uncertainty | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Absolute return hedge fund managers first aim to preserve capital (i.e: not be subjected to losses
with the rest of the market) and second try to deliver some profits to their investment partners
and investors. This preservation of capital is possible because the hedge fund manager will
generally budget his exposure to the following asset class risk:
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| Hedge Fund Strategy Descriptions | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Hedge fund managers employ diverse strategies that are difficult to categorise generically. There are few widely accepted definitions of strategies and there are many nuances to complicate such an exercise. Below, we have briefly described the HFA strategy classifications we use when analyzing our portfolios. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Market Neutral Equity | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Market neutral strategies attempt to profit from discrepancies between baskets of highly
correlated long and short positions in stocks. We define market neutral equity strategies as those
strategies that constrain the long vs. short positions within +/-10% range. Typically, the long
equity portion of the portfolio will include stocks with solid balance sheets, improving earnings
and moderate price/earnings and price/sales ratios. The short equity positions will include stocks
with weak balance sheets, declining earning, outdated products and high price/earnings and
price/sales ratios. Most of the market neutral equity strategies that our specialist managers
employ are broadly diversified and have more than 50 stocks long and 50 stocks short. Some market
neutral equity strategies concentrate on specific sectors of the market such as utility or bank
stocks. Market neutral strategies can also be broken down into geographic regions such as the
United States, Europe and Japan. Most market neutral equity strategies are constrained to being
equally long and short and do not take large sector or market capitalization bets.
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| Global Trading | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Global trading involves short-term statistically based trading in the global futures, debt, equity
currency and commodity markets. Portfolios are broadly diversified across positions and markets
and are traded 24 hours per day in all markets. Short-term forecasts are made based on past price
movements in order to predict future price movements. This strategy works best in periods of high
volatility.
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| Relative Value Arbitrage | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Relative value arbitrage is the pairing of one instrument that is believed to be overpriced with
another closely related instrument that is believed to be under-priced. Examples include
convertible bond arbitrage and merger arbitrage. In convertible bond arbitrage a convertible bond
is purchased while a short position is taken in the underlying company's common stock. This allows
for trading of both the convertible bond and common stock against each other as either instrument
becomes overvalued or undervalued relative to the other. Merger arbitrage involves buying the
common stock of a company involved in a takeover or merger attempt where the price of the attempt
is known. For example, if Company X is going to be bought for $30 and is currently trading for $27,
one could purchase Company X for $27 and wait for the transaction to be completed. The risk in
this transaction is that the deal is not consummated.
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| Long/Short Equity | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Similar to Market Neutral, Long/Short equity strategies involve the purchase of a long basket of
stocks hedged by a short basket of stocks. Unlike market neutral equity, there are no constraints
on the percentage of long securities vs. short securities. For example, a manager might be 80% long
and 20% short or 60% long and 40% short. This strategy tends to be more concentrated with typically
20 positions on the long side and 10-20 on the short side. Long/short equity can be broad in terms
of security selection or very focused in sectors such as technology and healthcare. Long/short
equity can also be specific to regions such as the United States, Europe, Japan or the emerging
markets. Typically, the long equity portion of the portfolio will include stocks with solid
balance sheets, improving earnings and moderate price/earnings and price/sales ratios. The short
equity positions will include stocks with weak balance sheets, declining earning, outdated
products and high price/earnings and price/sales ratios. The risk in long/short equity strategies
is that the manager is wrong on the long positions and wrong on the short positions or that the
manager has a macro view on value vs. growth, or small vs. large, that is not matched off between
the longs and the shorts.
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| Options | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Options strategies take advantage of believed mispricing in options volatility on a broad array of
securities including equities, bonds, currencies and commodities. The only factor that is not known
in order to calculate an options price is volatility. Volatility is constantly changing in the
marketplace. Options strategies tend to find what is believed to be cheap volatility and then wait
for an event where volatility increases. For example, if a biotech company is announcing the
results of a new cancer drug which will make or break the company, an options manager may set up a
trade whereby they buy a put and a call. In this way the manager can profit if the company's stock
skyrockets or plummets.
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| Trading | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Trading strategies tend to focus on persistent short-term profit opportunities in equity markets.
Typically, positions are held from 1-3 days and focus on sharp short-term price movements in
various sectors of the markets. By identifying which sectors are moving, a manager using this
strategy can target where large short-term price movements are likely to take place. Some managers
in this category rely completely on statistical information and past price behaviour while other
managers will rely on fundamental information to make a decision. This type of trading tends not
to use leverage and is highly liquid.
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| Regulation D | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Regulation D (Reg D) strategies derive their name from the portion of the USA Securities and
Exchange Act that allows for the issuance of private securities to a limited number of qualified
purchasers. Reg D managers negotiate private equity transactions with public companies at a
discount to the public company's current market price. Public companies like this type of
transaction because it provides them with quick financing instead of doing a costly and
time-consuming secondary public offering. Typically, a Reg D manager will sell the company's stock
as soon as the private issuance is approved by the SEC, thereby mitigating the equity market risk
the fund bears in the transaction.
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| Distressed Debt | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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This strategy involves the purchasing of debt that is not currently paying interest or is about to
stop paying interest. Once a company stops paying interest on its debt, the owners of the debt
begin to re-structure the company or sell the assets so that they can recover full value. At the
end of the restructuring, the debt might be paid back in full or converted to equity.
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| Short Only | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Short strategies involve the short sale of publicly traded equities. Typically, short managers
will look for fundamentally flawed companies where they believe the common stock is overvalued.
Short managers tend to be either technically or fundamentally driven; HFA's Diversified Fund tends
to use three or more managers for this allocation in order to lower volatility. This allocation
can be a drag on performance during a raging bull market, but is an excellent hedge to an overall
portfolio when equity prices fall sharply.
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| Fixed Income Trading | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Fixed income strategies attempt to profit from movements in bond prices. Fixed income strategies,
like relative value arbitrage, involve the pairing of one instrument that is believed to be of
higher value with another closely related instrument that is believed to be of lower value. Fixed
income arbitrage involves valuing either corporate, government or mortgage securities against one
another to find undervalued and over valued securities that are highly correlated. Long and short
positions are then taken in these securities.
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| Commodity Trading | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Commodity trading involves long and short positions in a basket of commodities based on
fundamental, technical or statistical analysis. The strategy can use any type of trade futures
instrument including equity, debt, currency and commodity futures. The most common type of
commodity trading is "trend following" whereby a manager identifies a series of indicators that
will predict a certain trend in an underlying commodity. Based on the signal, the manager will
either go long or short the commodity using a futures contract. Typically, these types of trades
tend to last from a few weeks to several months. Although any individual commodity contract may be
volatile, combining a number of different commodity markets will dampen overall portfolio volatility.
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