Category Archive: Wealth Management

  1. Introduction to Hedge Funds

    Leave a Comment

    Watermark-logo-horizontal-colour

    By Tim Bolger – COO

    The term ‘Hedge Fund’ has a tendency conjure up a wide range of connotations for the investing public. At the peak of their influence in the early 00’s and during their subsequent fall from grace in the lead up to the GFC, hedge funds have variously been among the best performing investment vehicles, a source of unbridled wealth for top money managers and at times, a pernicious force determining the fortunes of nations, currencies and corporations.

    Ironically, given the relative immaturity of the Hedge Fund industry in Australia, it was Australian born Alfred Jones who is credited as being the father of the hedge fund, launching the first iteration of a long/short equity fund in 1948. In those early days, the central axiom for hedge funds was a simple one; to manage risk through the use of hedging strategies.

    The modern hedge fund however is commonly considered to be a much more complicated beast, providing a broad investment mandate which allows fund managers to express investment ideas across markets, asset classes and financial instruments. Such exotic and unconstrained strategies must be distinguished from those that employ a simpler approach to investing, following the same primary objective that Alfred Jones had over 60 years ago.

    One product of an unconstrained investment mandate that sets Hedge Funds apart from ‘long only’ funds, is a focus on absolute returns rather that returns relative to a benchmark. In the context of equity investments, this is a marked deviation from the traditional institutional approach, which seeks to construct portfolios with reference to an index of shares. Viewing risk as the prospect of losing capital rather than of underperforming a benchmark, equity based hedge fund strategies can retain more flexibility to preserve capital and hedge against market falls.

    ‘Alternative Investment’ is a catch-all term applied to any investment that derives a return through an exposure to an asset other than the traditional asset classes, being shares, bonds, property or cash. As such, ‘alternatives’ comprise an eclectic mix of investment strategies and structures, which serve the common purpose of diversifying an investor’s portfolio through exposure to an asset class that demonstrates little or no correlation to other assets in the portfolio.

    Alternative Equity Strategies therefore seek to deliver returns that are uncorrelated to the underlying share market, using equities and equity-based derivatives as the component assets of their portfolio. While agreed conventions for nomenclature in the hedge-fund sector are hard to come by, in respect of alternative equity strategies one can categorise funds in terms of their exposure to the underlying share market. Specifically, long/short equity strategies can be loosely grouped into four categories:

    1. Extension (130/30, 150/50) Funds
    2. Variable Beta (directional) Funds
    3. Market Neutral Funds
    4. Equity Short Funds

    These strategies employ varying degrees of hedging as part of their investment strategy, to amplify, limit or eliminate an investor’s exposure to movements in the broader share market, otherwise known as market ‘beta’. Further iterations of these categories commonly found in the Australian marketplace include Event-driven and Global Macro funds.

    Typically risk is managed in a portfolio by reducing exposure to risky assets in favour of defensive assets. Put simply, if an investor is worried about the outlook for the share market, they may sell some shares and increase their allocation to cash. Hedging strategies allow an investor to manage market risk, while retaining exposure to an investment that offers the potential for a return greater than cash. Rather than using the trade-off between cash and shares, a long/short investor who is nervous about the outlook for the share market may retain the shares they own and reduce equity market risk through the introduction of hedging.

    A common hedging strategy for investors in shares is to short-sell securities. By creating a liability whose value is linked to the market price of a security, an investment is hedged whereby a market fall which weighs on the price of all shares will reduce the value of the asset they hold (long), while simultaneously reducing the size of their liability (short). In balancing the relative sizes of the long and short portfolios, a long/short investor can manage their exposure to movements in the underlying market.

    Utopia for a long/short manager is where the long portfolio goes up, the short portfolio goes down and all positions are profitable in their own right. The reality of markets however, renders this ideal outcome very rare. It is the way in which long and short portfolios behave relative to each other when impacted by external forces, which demonstrates the power of a long/short investment strategy. Irrespective of the prevailing direction of the market, a long/short investor will profit to the extent that their longs do better than their shorts. Thus the correlation between equity market returns and the performance of long/short investments falls as the level of hedging increases and in the case of market neutral or short portfolios, it is common to see zero or negative correlations.

    As the amount of hedging in a portfolio increases the impact of market ‘beta’ is reduced, which works against a long/short investor in rising markets. Stock selection therefore is critical to a successful long/short equity strategy which cannot rely solely (or at all) on rising asset values to generate returns. While the most successful equity long/short strategies may produce ‘equity-like’ returns, it is important to remember that these returns are more reliant on a manager’s skill and less on market beta. Investors’ expectations should be guided by the manager’s investment objective and the performance of comparable strategies, rather than share market returns more broadly.

    Due to the relatively higher level of complexity associated with long/short strategies, they have typically been the domain of sophisticated and institutional investors. In the context of Listed Investment Companies (LIC’s), which are dominated by large funds employing variations of a ‘buy and hold’ strategy, long/short strategies are also rare. Many of the qualities that characterise successful long/short investments render them well-equipped to meet the key objectives of an LIC; namely, to deliver consistent portfolio returns over time and to pay a steady and growing stream of franked dividends to shareholders. Similarly for investors in retail managed funds, long/short investments are useful in the construction of robust investment portfolios

    Long/short strategies have the capacity to generate consistent returns with lower volatility through a market cycle. In the context of an LIC, the ability to protect the company’s capital during periods where equity market returns are poor and potentially profit from falling markets enables the company to protect its dividend paying capacity as funded by retained profits. This stability of returns and predictability of dividend paying capacity are of particular importance to classes of investor to whom income and capital preservation are of paramount importance.

    Like any investment, Alternative Equity Strategies have their own risk/reward dynamic and must be weighed on their merits. Statistical analysis has shown however that returns from these strategies have little or no correlation with the broader share market or in fact with each other. As such, they are one of the few investment options that offer investors genuine diversification in a portfolio.