Hedge funds set to blossom in 2007
Hedge funds develop deep roots Hedge funds are here to stay. Not only are larger numbers of institutional investors committing to this sector but hedge fund investment techniques are increasingly being adopted by traditional asset managers. Those who are cautious about hedge funds voice concerns about risk levels, lack of transparency, low liquidity levels and high fees, but the attractions of high returns and low correlations are highly persuasive. Therefore, it is important when selecting a manager to find one who offers education about the strategies employed and explains their investment approach clearly. For those investors who have taken the plunge, risk remains a key focus. However, rather than being a concern, they are actually employing hedge funds to mitigate the risk in their portfolio. In Mercer Consulting’s 2006 global survey on funds of hedge funds investing, investors who have made investments into hedge funds have done so to either provide: “an equal combination of portfolio risk reduction and return enhancement or primarily for risk reduction” In addition, having sampled these strategies, 53 per cent of respondents expected to increase their allocations over the next two years, with the median hedge fund allocation expected to increase from 5 per cent to 7.8 per cent over the same period. Thus what should we understand before considering an allocation?
Hedge funds: a recap Like other asset managers, hedge funds generally invest in public markets for their clients, buying and selling equities, fixed income, currencies and commodities. Where hedge funds differ is that they do not face many of the constraints that traditional asset managers do. They do not follow benchmarks, may borrow money to invest, sell securities short and use instruments such as derivatives to express views and manage risk. The underlying philosophy of hedge fund investing is that the skill of the manager, rather than the return of the market, is the key determinant of how they will perform. Why consider an allocation? Portfolio diversification is a key reason investors cite for making a hedge fund allocation. Given the greater degree of investment freedom and types of techniques employed by hedge fund managers, it is likely that hedge fund investments will not behave like more traditional strategies in your portfolio. Many hedge funds place great emphasis on disciplined risk management and historically hedge funds in aggregate have provided returns at lower volatility than the stock market. It is often common for them to invest a portion of their own capital, which is an indication that of their willingness to align their interests with their clients. Not a single asset class A common misconception is that hedge funds behave as a homogeneous group. This fails to recognise the immense variety of strategies they employ and the differing risk performance and profiles of each. In addition, the industry continues to evolve and, as managers seize new opportunities and make use of innovative financial instruments, the number of strategies continues to increase. With a universe of over 9000 funds today, the gap between the best and the worst is enormous, which can make manager selection challenging. Investment options Many investors considering hedge funds for the first time have opted for a fund of hedge funds whereby dedicated investment professionals are responsible for evaluating strategies, identifying managers, performing due diligence and ongoing monitoring. Many of these funds aim to offer diversification across manager styles as well as sectors, and hence tend to offer a lower degree of risk than a single hedge fund investment. However, this approach does incur additional fees and all investment decisions need to be made in the light of the circumstances of the individual portfolio objective, but 2007 may be the year for hedge funds to have a greater place in more portfolios than ever before.
