Hedge Fund Investing
An option for the super rich?

What are hedge funds? They are aggresively managed private investment funds that charge a performance fee in addition to the usual mutual fund fees and are typically open to only a limited range of qualified investors.

They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

So to find the best hedge fund one needs to be confident that the (hopefully positive) performance of the fund is due to the skill of the fund manager (since that is what you are paying extra for), and is not just related to the fortuitous movement in the market.

Hedge fund directories such as HedgeFund.Net provide information on the wide range of funds available, including value funds.

The types of funds available are many and varied and include green hedge funds, emerging markets hedge funds, and commodity hedge funds - as examples of the diversity.

These funds commonly include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisors, can invest in riskier investments than a public fund might.

They can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.

Their investment activities are limited only by the contracts governing the particular fund.

As their name implies, they often seek to offset potential risk by hedging their investments using a variety of methods, most notably short selling.

However, the term has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other 'hedging' methods to increase returns, and therefore risk.

Most are designed and sold on the premise that they will make a profit regardless of market conditions. Losses are not supposed to happen. However, hedge fund collapses do occur.

Being outside the regulatory regime that applies to retail funds greatly reduces the information that this type of fund is legally required to make public. So they have acquired a reputation for secrecy.

Their sway over markets is potentially substantial as they control funds amounting to hundreds of billions of dollars.

This is magnified by leverage. As a result, there is ongoing debate as to whether they should be more thoroughly regulated.

Legally, they are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment.

Investments in this type of fund are illiquid as they often have lock-up policies or 'gates' that require investors keep their money in the fund for at least one year.

Some investors learned this the hard way when a number of funds were hit hard in the current 2008 market turmoil and they were not able to withdraw all their money when they wanted to.

Also, it cannot be assumed that all these funds offer diversity as some target specific markets. Some funds provide diversity by adopting a 'fund-of-funds' approach where a fund invests in a variety of other funds. A cynical observer (including me) could regard this as a 'fee-on-fees' approach.

Unlike mutual funds, they are unregulated for the most part because they cater to so-called sophisticated investors who must have assets of at least $US1 million or have an income exceeding $US200,000 in each of the two most recent years.

In summary, they can be thought of as mutual funds for the super rich.

I do not invest in this type of fund as such, but in absolute return funds that share some of the characteristics of hedge funds, such as short selling. They also do not require as large an initial investment - typically $A25,000.

The term 'absolute return' refers to the approach which attempts to produce a positive return, irrespective of the direction that the market is taking at any point in time.

As the portfolio of an absolute return fund is the product of individual stock picks, it is not uncommon to have constituents that differ significantly from traditional benchmarks such as the MSCI.

I invest in those with a value investing approach that involves buying undervalued companies and holding them until they become overvalued. As well, I like to see the operators of the fund having significant amounts of their own money invested in the fund.

There is nothing that concentrates the mind more than putting your money where your mouth is!

Return from Hedge Funds to Managed Share Funds