What is a hedge fund?
This article was produced by HSBC Alternative Investments Ltd, the investment advisor to HSBC’s fund of hedge funds and institutional client portfolios.
A frequently expressed view is that hedge funds are very risky and, although investors may earn significant returns, they are at high risk of losing a significant proportion of their capital. A major problem encountered by investors, in dispelling this view when approaching the hedge fund sector, is the large amount of "jargon" encountered as well as the considerable confusion as to what hedge funds actually do.
Confusion can arise from the simple term "hedge" that implies that hedge funds are simply running hedged positions, which is not always the case. An understanding of these vehicles is also hindered by some media focus on the relatively infrequent but newsworthy stories that attract attention. Stories such as George Soros’ role when Sterling was forced out of the ERM; or the collapse of Long Term Capital Management are more newsworthy than the fact that the average hedge fund was up 4.4% in 2001 (according to CSFB/Tremont) versus significant falls for equities that year.
When many investors think of hedge funds, they think of the so-called macro approach to hedge fund investing that offers the manager great flexibility in the choice of markets and instruments used. Whilst rewards can be high, this represents one of the higher risk hedge fund strategies available to investors.
According to Hedge Fund Research Inc, macro managers made up over 70% of the hedge fund universe (by assets) in 1990. This proportion reduced significantly over the years. By December 2005 it was estimated that macro managers made up only 11% of the overall universe of hedge funds. As the charts below shows, whilst this strategy is still significant, the number of absolute return strategies being used has increased considerably, which allows for the creation of properly diversified hedge fund portfolios.
 |
 |
| Hedge Funds | Traditional Funds | |
|---|---|---|
| Returns in positive markets | Often catch a good proportion of upside | Similar to underlying market |
| Returns in negative markets | Significant reduction in downside | Similar to underlying market |
| Volatility reduction | Good | Volatility similar to underlying market |
| Correlation to market direction | Low to medium depending on strategy type | High |
| Investment instruments and techniques | Flexible | Rigid |
| Remuneration | Large proportion is performance related | Generally fixed annual fees, but can also be performance related |
| Investment by Manager in own Fund | Generally involving meaningful sums | Varies |
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