Continuing from our last article (Feb. 20), entitled “Reaping the Rewards From a Volatile Market,” we received many calls from investors asking how they should practically incorporate funds into their portfolio which are not sensitive and hence vulnerable to the stock market downturns (hedge funds) which have caused concern recently.
Dictionary definition of Hedge Funds:
All forms of investment funds, companies and private partnerships that 1) Use derivatives for directional investing, 2) And/or are allowed to go short, 3) And/or use significant leverage through borrowing.
In layman’s terms—what does this mean?
Hedge funds look to make returns for investors in absolute terms. Whereas an equity fund may aim to outperform its respective index or other comparative benchmark, a hedge fund concentrates solely on net profit to the investor after fees. In addition, fees are heavily reliant upon performance further motivating the managers to find profit opportunities.
How does this differ from the aims of a traditional fund?
A traditional equity fund manager who managed to lose only 10 percent when the stock market index was down 15 percent would be heralded as a first class manager. A hedge fund manager who lost money over the same period would be somewhere at the back of the pack.
So “What about my portfolio?” Below we have summarized the questions asked and answers we give to our investors to provide more of an insight into the investment considerations.
What percentage of my portfolio should be allocated to hedge funds?
Former research indicates the optimum balance may be a maximum of a 30 percent allocation to hedge funds. This however applied to more volatile single trader funds. Modern hedge funds however, which may “blend” as many as 20 traders to provide returns from all sectors, are far less volatile to the extent that some have had no losing months for the number of years. Investors using these funds can allocate a far higher proportion of their capital to a safe, non-stock market reliant strategy.
Which type of hedge funds should I buy?
We recommend principally multi-manager funds with proven consistent track records in line with their stated objectives and a well-defined risk profile. We are not interested in funds which provide surprises.
Are hedge funds expensive to buy?
The fees associated with hedge funds are principally performance-related. Investors wishing to decipher the often complicated fee schedule of multi-manager funds can take heart in the fact the month end reported returns are always quoted net of all fees and charges. Front end fees are usually lower than entry fees on traditional funds and others may have a redemption fee in the first few years, encouraging investors to take a medium term view.
Are they really as invulnerable to stock market crashes as they sound?
There is no perfect fund. There are conditions in which hedge funds have losing months, though research shows these are far less frequent than the positive months.
However, let’s take the recent “Asian Crisis” as an example (which in fact became an emerging market crisis). Traditional equity funds diversified in Southeast Asia tumbled 22 percent by 1997 year-end, while those invested in Latin American stocks saw their portfolios decline 20 percent on the year. The only conventional asset class to post positive returns in October’s meltdown were bonds, as yields fell to 18-month lows on the U.S. 30-year Treasury.
Tass, the hedge fund research group, estimates the 27 dedicated Asian hedge funds it tracks returned 4.5 percent for the 1997 year to November. They generally prospered after November, profting from from ongoing volatility. Hedge funds with a global mandate had a good year, with returns for the leading “multi-manager” funds we track ranging from 14 percent at the more cautious end, to 23 percent for more aggressive funds.
If I move part of my existing portfolio into hedge funds, do I need to think about market timing?
One of the investment maxims of a hedge fund is that there is never a good or bad time to buy or sell. Due to the diversified trading strategies within the fund, such issues as stretched price/earnings ratios and overvalued markets do not apply. On the issue of the timing of the sale of existing assets, there will be additional considerations.
In summary…
The diversification, opportunity for profit in all market conditions and reduction in volatility that hedge funds bring to a portfolio make them an essential ingredient. Investors are likely to hear more and more about “alternative strategies” as the world of hedge funds opens up to the private investor. We aim to be at the forefront of this exciting development.
If readers would like a copy of The Tresidder Tuohy Guide to Alternative Investments or more information regarding hedge funds, please call Alison Pockett or David Spratley at Magellan Tresidder Tuohy at 3582-3773.
