Trends in Hedge Funds
2005 - When most investors think of “hedge funds,”
they think of Long-Term Capital Management (LTCM), a hedge
fund that almost collapsed in 1998, nearly taking America’s
financial infrastructure with it. Most investors consider
hedge funds to be volatile, risky, leveraged investments
with high fees and little transparency.
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.
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.
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.
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.
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.
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.
Papier, CIMA CFP, manages the New York office of
Lexington Bridgewater Wealth Management (www.lexingtonbridgewater.com).
He can be reached at 212-697-3930 or firstname.lastname@example.org.