Investors still need to hedge their bets

IN THE aftermath of the credit crunch, investing in hedge funds may no longer be seen by many as sensible or even respectable. But the benefits that a well diversified and actively managed portfolio of hedge funds can provide are crucial to a balanced portfolio.

Many investors find it difficult to understand the strategies employed within a hedge fund portfolio and this stops them from entering what can be a very efficient way of managing money. So what do they need to know?

It is widely believed that the first hedge fund was created by Alfred Winslow Jones in 1949 when he was researching unusual trading methods for the Fortune magazine. Jones structured his own investment fund, set it up as a partnership and became general partner.

This structure is important because it made the fund exempt from regulatory control and allowed Jones to use techniques not open to typical investment managers. His main strategy was to offset the equities held in the fund portfolio by short-selling other equities to balance those positions. Jones was effectively "hedging" his purchases in the stock market.

Capital raised from the short sale of equities could then be reinvested to purchase more equities by leveraging the amount originally invested to enhance returns. An incentive fee was introduced to ensure that when the investor benefited, so did the manager.

It was this equity long/short strategy that went on to be coined a "hedge fund" in 1966 when another Fortune magazine article highlighted how Jones' fund had outperformed the best mutual fund that year by 44 per cent.

Two years later, there were 200 hedge funds in operation, including those formed by George Soros, and by 1970 it was estimated the assets controlled by hedge funds totalled some $1 billion. Today the figure is some $1.6 trillion.

The majority of hedge funds seek to maximize returns regardless of market conditions. A manager will typically buy shares and hold them until the price rises, at which point the stock is sold for a profit. But reverse trade is also profitable. This is when the manager sells stock he does not own, or short-sells.

Short-selling means the manager must borrow the stock for a fixed period of time. He must then return an equal number of shares at the end of the period. In this way, profits may be achieved when the markets are going down.

Many hedge fund managers borrow additional capital to invest alongside their investors' money, a process called leverage or gearing. Another way is to purchase derivatives based on the underlying asset.

There are two main types of derivatives: futures and options. A future is a contract which fixes the price of an asset at a future date.The purchaser must purchase the asset on the maturity date at a pre-determined price.

Call options are similar to futures although the purchaser is not obliged to buy. A put option gives the purchaser the right to sell an asset at some point in the future for an agreed price.

Hedge funds typically charge two types of fee. The first is a fixed annual management fee that usually ranges from 1 per cent to 2 per cent. The second is a performance-based fee that is directly linked to the performance of the fund. The manager takes a proportion of the profits generated by the fund, ranging from 10 per cent to 20 per cent.

Typically unconstrained by benchmarks, hedge funds have the flexibility to use leverage and derivatives to achieve their return objectives. Hedge funds can also benefit from falling prices. Investors can potentially gain from return streams that are otherwise inaccessible in the traditional investment universe.

The addition of hedge funds to a typical portfolio invested with bonds and equities brings diversification and enhances returns over the long term. When the stock market is doing well, hedge funds capture a good proportion of the upside. But when there is a downturn, the benefits of holding hedge funds are more apparent.

Although hedge funds do not guarantee capital protection and take market risk through betting on market directions, their ability to limit downside is crucial to long-term successful investing.

There are also aligned interests. Typically, a substantial amount of the manager's money is invested in these funds.

These are all strong reasons to consider hedge funds as a way of investing. But assessing the quality of the underlying managers is essential and requires investors to be strong, experienced and robust.

• Guy Tulloch is head of Scotland for HSBC Private Bank