What are hedge funds?

The RBA says the term ‘hedge fund’ is typically applied to “managed funds that use a wider range of financial instruments and investment strategies than traditional managed funds, including the use of short selling and derivatives to create leverage, with the aim of generating positive returns regardless of overall market performance(2).

In other words, hedge funds aim to ‘hedge’ or manage the risks of a volatile market by using a variety of investment strategies.

Myth no.1 – hedge funds are only for the very wealthy

This may have been true in the past, but these days, investors can access hedge funds with as little as $20,000.

Myth no. 2 – hedge funds are risky

Most hedge funds are active managers of investment risk with defensive strategies in place.

An index fund, perceived by some as a ‘safe’ option, is at the mercy of the volatility of the market it tracks; susceptible to fluctuations which aren’t actively managed. However, a market neutral hedge fund targets a positive rate of return regardless of the return the market, which means the risk is actively monitored, positions are hedged and exposure to the market limited as required.

Some hedge funds are purely focused on preserving capital (ie. your original investment), so making strong returns over the short term is not their primary focus. Other hedge funds only trade when opportunities arise and have clear investment guidelines which act as a framework for their investment decisions – such as exposure limits, risk management frameworks, stop loss levels, etc.

Before you select a hedge fund, undertake your due diligence – people and processes are critical, as is a robust framework for managing risk.

Myth no. 3 – hedge funds have exorbitant fees

The typical hedge fund fee structure in Australia is 1.5% management fee and 20% performance fee. At fi rst glance, this appears to be high when compared to long-only domestic managers. To see true value for money, however, you need to focus on returns not just fees. If you’re paying very low fees but the fund is not performing, this is a false economy.

Performance fees are only payable when the fund outperforms the benchmark, meaning investors pay for the manager’s skills and expertise when they’re getting a good return on their investment.

Myth no. 4 – hedge funds are illiquid

In Australia, redemption restrictions and high withdrawal fees are rare. There are a number of retail hedge fund managers in Australia who price their fund daily and most have a straightforward redemption process with relatively low withdrawal minimums ($10,000).

Myth no. 5 – hedge funds are unregulated and lack transparency

In Australia, hedge funds are as tightly regulated by ASIC who have recently introduced changes to reporting and increased investment process transparency, which will further improve the current status quo.
Transparency and openness around investment processes, internal governance and compliance controls is critical when assessing hedge fund managers.

Conclusion

Hedge funds play a unique role when teamed with a portfolio of more traditional investment products. They can reduce volatility and increase returns. Next time you’re creating a personalised portfolio, consider adding a hedge fund to the mix. Speak to our friendly Financial Planning Team today.

1 http://www.basispoint.com.au/hedge-fund-directory/
2 http://www.rba.gov.au/publications/fsr/2004/sep/pdf/0904-2.pdf
Source: Bennelong Funds Management, August 2013

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