Inside hedge funds

Hedge funds are actively managed investments that aim to produce returns in both rising and falling markets through the use of a diverse range of securities and investment techniques.

The techniques used by hedge fund managers may be different to methods employed by traditional fund managers, as the funds generally have greater scope to use derivatives, short positions and exotic securities. A hedge fund manager may choose to specialise in one or more of these areas. If they specialise in one area, the fund is a single strategy fund. If they specialise in several areas, it is a multi-strategy fund. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded, or other risks associated with their investment world.

When evaluating hedge funds it is appropriate to distinguish between - fund of hedge funds (FOFs) on the one hand and single strategy and multi-strategy funds on the other. Strategies that may be used by hedge fund managers include:

• Short selling - where the manager borrows a security and subsequently sells the security with an obligation to purchase back the security and return it at a later date. This technique is utilised where the manager believes the security is overvalued or as part of a hedge or arbitrage strategy.
• Hedging - where the manager utilises two or more securities that are likely to move in opposition to each other, thereby mitigating risk.
• Arbitrage - where the manager attempts to profit from a temporary pricing inefficiency or discrepancy in either an individual security or a securities market. This technique may involve short selling and/or hedging.
• Low liquidity or distressed securities - where the manager attempts to earn returns through investments in low liquidity or distressed securities outside the investment mandates of traditional fund managers.
• Leverage - where the fund manger borrows or gears the assets of the fund to increase the size of the investment portfolio and potentially earn greater returns.

Managers will seek profit opportunities arising from inefficiencies in the market for such securities and other obligations. Profits in this sector result from the market's lack of understanding of the true value of the deeply discounted securities or its underlying assets and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount) Results are generally not dependent on the direction of the markets.

Know what you're buying

As you can see by the range of strategies, each hedge fund has it's own risk and reward characteristics, with many of the strategies solely reliant on the skill of the fund manager. So before you consider investing, take some time to learn about the investment strategies used by the manager, and also what fee you are paying for their expertise.

Who invests in hedge funds?

Historically, high net worth individual investors, who have wanted to protect their investments at a desired level of risk. But this has changed - no longer are hedge funds the high-risk investments favoured by the wealthy. Hedge funds are now being structured using different strategies to cater for all risk profiles.

Hedge funds may be appropriate for investors seeking:

• Potential returns in rising and falling markets.
• Diversification into non-traditional financial instruments and management techniques.
• An investment with low correlation to shares, property, or fixed income.
• Returns from both income and capital appreciation.

To find out more on these strategies and if they are relevant to your personal circumstances please give us a call.

Any advice in this publication is provided by AMP Financial Planning (AMPFP). AMPFP is part of the AMP Group of companies. No remuneration or other financial benefits are paid to AMPFP or its related companies or associates for providing advice in this publication. Any advice in this publication does not take account of your personal circumstances. Before relying on it to make a decision, you should consider how it applies to your overall circumstances or speak to a financial planner. Before deciding whether to buy or continue to hold any financial product including those referred to in this publication, you should also obtain and consider the Product Disclosure Statement for the product, which is available from your financial planner. Although this information was obtained from sources considered to be reliable, it is not guaranteed to be accurate or complete. The information in this publication is current as at the date of publishing and may change over time. Past performance is not an indication of future performance.