Current Trends in Hedge Funds

By Edward Papier

E-mail Story Print Story

A new category of hedge fund investments, often referred to as “absolute return” investments, attempts to achieve traditional equity-market returns with the volatility associated with the bond market. These funds are sometimes registered with the SEC, allowing more investors to participate (sometimes with as little as $25,000). In addition, registered vehicles that are also regulated avoid unrelated-business income tax (UBIT) for any tax-exempt entities, such as private foundations, that invest in them.

Because there is no evidence of persistence in a manager’s out-performance, sometimes referred to as “alpha” or excess returns, above an index, a hedge fund of funds (FoF) can be used to mitigate the risks associated with individual hedge funds. These are becoming more widely accepted by institutional and high-net-worth investors.

Hedge funds employ various investment strategies, which generally fall into four major categories: relative value (capitalizing on pricing inefficiencies among individual securities); event-driven (investing on anticipated outcomes of company-specific situations such as a merger); long/short equity (taking both long and short positions in securities); and global macro (seeking to benefit from macro-economic opportunities in the global equity, fixed-income, currency, and commodities markets). Because these strategies go in and out of favor, investing in a FoF should enable a portfolio to have significantly lower volatility than if it used only one investment strategy alone. The Exhibit depicts the returns for a number of these strategies for 1990–2004. The data suggest that investing in multiple styles generates less volatility.

Because hedge fund returns have historically had a low correlation to traditional investments, including them in a portfolio may improve returns while reducing overall volatility. An investor might allocate 5%–20% of a portfolio to hedge funds, depending upon the type of hedge fund used, the investor’s risk tolerance, and the time horizon for liquidity. Many hedge funds have less liquidity than do traditional instruments.

Another recent development in hedge fund investing has been the creation of investable hedge fund indices. Like index mutual funds, index hedge funds are typically created using a variety of quantitative and qualitative screens in an attempt to represent the broad hedge-fund universe.

While once reserved for sophisticated institutional investors, FoFs are moving “downstream,” enabling more investors to have greater access to them. While a few hedge funds have gained notoriety as a result of risky trading strategies, hedge funds also employ a variety of less volatile investing strategies. Hedge funds do, however, contain many risks that investors must thoroughly understand before investing in them. Many FoFs are designed to minimize volatility and may offer investors a prudent way to enhance their portfolio’s risk-adjusted return by allocating a portion to hedge funds.