In recent years, hedge funds have become an increasingly prominent part of the lexicon of investing. The strategies and performance of hedge fund managers have gained wide attention, particularly last year when the collapse of Long Term Credit Management (LTCM) almost caused a global financial meltdown. Since that event, hedge funds have generally been portrayed by the media as extremely speculative, high-risk and mysterious investment vehicles. They have also been accused of practically sabotaging the world financial system. But are hedge funds the real villain and should they be ignored by all but the most speculative of investors?
To begin with, let us first look at what a hedge fund is. The first hedge fund started trading in New York on 1 January, 1949 and was managed by Alfred Jones. The fund took both short and long positions in the same portfolio with the objective of increasing returns while simultaneously lowering risk by reducing the overall net exposure to the market.
Different investment strategies
Jones’ fund quickly proved successful, which led to the creation of a number of other funds employing similar investment strategies. However, the real explosion in hedge funds has taken place during the past decade.
In the late 1980s there were less than 100 hedge funds compared with a number believed to be more than 3,500 today. It is estimated that hedge fund assets now total more than $400bn, although it is difficult to be too precise about these figures since many of the funds still operate in secrecy and with very little regulatory supervision.
One part of the problem for hedge funds has been the fact that the industry has become associated with the exploits of names like George Soros, John Meriwether (at LTCM), Julian Robertson and other ‘macro’ traders, who engage in taking big bets on the movements in global capital markets. However, this is only one small sector of an industry, which actually includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. For example, hedge funds can be grouped into these four major categories, each of which has several sub-strategies:
l Market neutral or relative value – these strategies do not depend upon on the general direction of market movements. Managers seek to exploit market inefficiencies, looking for disparities in pricing relationships between instruments with similar pricing characteristics. Because these funds are market neutral, the returns of the funds are essentially non-correlated with benchmark indices and so offer excellent opportunities to diversify a portfolio.
l Event driven – these strategies are based on the actual or anticipated occurrence of a particular event, such as a merger, a bankruptcy announcement or a corporate re-organisation or spin-off. The returns from these funds are relatively unaffected by the direction of equity and fixed interest markets.
l Long/short – similar to the original fund, these strategies invest in equity and/or fixed interest instruments, combining long and short investments to reduce market exposure and thus isolate performance of the fund from the performance of the asset class as a whole.
l Tactical trading – these funds speculate on the direction of the market prices of currencies, commodities, equities and bonds in the futures and cash markets. This is the most volatile sector in terms of performance, although it exhibits a low correlation with traditional market benchmarks. This sector also includes the aforementioned macro players.
