The key features of hedge funds – understand them better

What is a hedge fund? And what is it about hedge funds that makes them different from other investment products, like mutual funds? In the first part in our educational series about hedge funds, we go back to basics, looking at what hedge funds are and the key features of the asset class.

Geopolitical issues and rising inflation have created a challenging environment for equities. Investors are seeking investment options that diversify away from the risk in traditional asset classes and can also provide some downside protection during stressed markets. So, it isn’t surprising that investors are increasingly turning to hedge funds to meet these needs.

Over the last 30 years, Aurum has not seen any other liquid asset class deliver the type of uncorrelated, consistent return stream that hedge funds have provided.

As more investors seek downside protection, whilst maintaining upside potential, a case can be made that hedge funds have never had a more important role to play. However, hedge funds are complex investments following a wide variety of different investment strategies. There is also wide dispersion of returns across the industry.

With many investors looking at hedge funds for the first time, we thought it was a good time to provide some basic background and explore:

• what hedge funds are
• why investors include hedge funds in their portfolios
• some common myths about hedge funds and the reality
• why not all hedge funds will offer investors the protection investors seek
• some of the main hedge fund strategies and jargon used

In this four-part series, we will explore these topics. We will demonstrate the potential value well-selected hedge funds can bring to investors’ portfolios, but also the potential pitfalls of hedge fund investing.

What are hedge funds?

Hedge funds evolved to solve a problem for investors. Put simply, hedge funds were designed to generate real returns for investors, while protecting them from losses when markets fall.

At the most basic level, hedge funds are pooled investment vehicles which are largely unconstrained in the investments they can make. They can typically use a variety of investment instruments and strategies to generate real returns and mitigate risk. You can find an overview of the strategies that hedge funds employ here.

Hedge funds are not only able to go long in securities (e.g. equities/bonds) that they think will go up in price, but also to “short” securities that they expect will fall in price.

This is done by borrowing the securities (usually lent by a broker at a cost, which have to be returned at a later date) and selling the borrowed securities at the current market value. The securities are then repurchased at a later date, by which time the hedge fund hopes that the securities have fallen in price, and are returned to the lender. Being able to short is one way hedge funds are able to make profits in a falling market.

Key features of hedge funds:

Return enhancement

Hedge funds have the ability to use leverage, which means they can use borrowed money to increase the size of their positions in order to enhance returns. Although this also carries the risks of magnifying potential losses.

Risk management

The best hedge funds are specialists at minimising investment risks and make risk management an integral part of their investment plan. Conscientious risk management serves to limit losses and promotes more consistent, generally higher risk-adjusted returns.

Terms

Hedge funds differ from traditional “long only”, mutual funds in structure and investment terms:

• Absolute Return – whereas long only fund performance is generally tied to a benchmark, hedge funds target “absolute return”, regardless of the performance or direction of markets
• Performance Fee / Incentive Fee – hedge funds typically have a different fee structure – both hedge funds and long only funds generally charge a management fee, however hedge funds may also charge an “incentive” or “performance” fee, which is a percentage of the positive performance of the fund
• Minimum investments – hedge funds usually have high minimum investment amounts. They are not typically targeted at retail investors.
• Liquidity – the liquidity of long only funds and hedge funds also differs, whilst long only funds largely offer daily liquidity, hedge fund redemption dates tend to be monthly or quarterly (some are even longer), and have extended notice periods. Some hedge funds demand lock-up periods.
• Structure – whilst long only funds are managed and domiciled onshore (for example through European UCITS structures), hedge funds tend to be domiciled offshore, often in the Cayman Islands, Bermuda etc. That being said, the onshore presence of hedge funds is growing significantly, particularly in Ireland and Luxembourg.

In part two of the hedge fund basics series, we will look at why investors include hedge funds in their portfolios.