The name comes from the “hedging” techniques funds use to manage risk, although not every fund hedges.
Hedge funds invest in a range of assets and instruments, adopting both long-only strategies – buying an asset in the hope that it will rise in value – or shorting assets they expect to fall.
Many investors use hedge funds to offset risks elsewhere in their portfolio, says Tom Elliott, an international investment strategist at deVere Group in Dubai. “Hedge funds can get into illiquid assets, short positions and complex derivatives, which traditional mutual fund managers are barred from using. This leads to a low correlation of returns with mutual funds, and that reduces the investor’s overall portfolio risk.”
It is this that makes them so attractive to sophisticated, wealthy investors. “Hedge funds are great diversifiers, reducing the impact if one asset class goes sour,” Mr Elliott adds.
The vast majority of hedge fund managers are not taking spectacular bets, but doing the reverse – investing in assets that provide smaller gains with more assured safety. But it is the risk-takers who grab everybody’s attention.
There are two types of hedge fund manager, says Jim Wood-Smith, head of research at Hawksmoor Investment Management in London. “First, there are those who are true to the original conception, hedging risks to achieve a slightly better return than you would get on cash, with minimal volatility. Hedge funds were originally a means for the very wealthy to stay that way.”
These managers are largely anonymous, but knuckle down to the less-than-heroic task of grinding out steady returns from their portfolios, day in and day out.
The second type of hedge fund manager is the risk-taking superstar, Mr Wood-Smith says. “They hope that by taking enough big bets one or two will hit the jackpot and propel the manager to global guru status.”
Gambling is a mug’s game, but hedge funds cannily fix the odds in their favour by investing with other people’s money. “Hedge fund losses fall on the investors, while the gains largely transfer to the manager in the shape of hefty performance fees.”
Many hedge funds charge annual fees of 2 per cent, plus 20 per cent of any profits on top. This is known as the 2/20 fee structure.
Yet although they take a share of any profits, the losses are all yours, Mr Wood-Smith says. “It is a cliché to say that running a hedge fund is like going to the casino with someone else’s money and keeping all the winnings, but it is close to the truth.”
Sadly, that is one strategy no private investor can emulate.
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