Why should you invest in a hedge fund?

Geoff Blount, managing director of BayHill Capital.
Geoff Blount, managing director of BayHill Capital.

In a low-return or a volatile market, any investment that gives positive returns is worth considering as an investment strategy. Given that global interest rates are low – and likely to remain so – and equity returns are expected to remain subdued, alternative investments offer the best hope for positive returns.

Hedge fund returns are uncorrelated with those of traditional asset classes: equities, bonds, property and cash. They aim to provide a positive return during rising and falling markets and therefore add an element of diversification to an investor’s portfolio.

In addition, given that hedge funds can benefit from a falling market, they can offer a significantly different return profile to the underlying asset they play in.

But a word of warning: hedge funds will not necessarily provide exceptional returns. Some investors seem to hold extravagant expectations for hedge funds, and while it is dependent on the underlying strategy, a return of 10% to 15% p.a. over time should be considered very good.

Hedge funds are sometimes referred to as a new asset class. We would rather describe them as offering a different way to invest in existing asset classes – the underlying assets in which most South African hedge managers typically invest in are the traditional asset classes.

Long and short positions

One of the key aspects of a hedge fund is that the manager can take long (buying assets that they think will rise) and short (selling assets they think will fall) positions – called a long/short strategy. Being able to short an asset means that the manager is not dependent only on rising asset prices to make money.

Sometimes a hedge fund will own direct shares, but more often than not, they invest via derivatives – such as futures, options and contracts for differences (CFDs) – to achieve the positions.

Hedge funds can have a long bias where their performance is more correlated to rising prices, or a short bias where their performance is more driven by falling prices. However, many hedge funds are managed in a market neutral way. In this instance, the manager balances the long and short positions to remove directional bias in the portfolio.

Market Neutral Trading

Using the example of going long share A at R10 and going short share B at R10, the following payoff is possible:

 –      A goes to R11 and B goes to R9                  +R1 + R1 = Profit R2

–      What if A goes to R9 an B to R11                - R1 - R1 = Loss of R2

 

And if there is a rally or crash?

–      What if A goes to R12 and B to R11           +R2 - R1 = Profit of R1

–      What if A goes to R9 and B to R8                - R1 + R2 = Profit of R1

 As can be seen from this example, what matters in profiting from a market neutral trade is the relative performance. 

As long as Share A outperforms Share B irrespective of market direction, the trade will make a profit.

In addition, hedge funds are able to use leverage (borrow within the portfolio) to magnify the exposure to the underlying asset. While affording much greater upside potential, this equally increases the downside risk if your position goes against you.

But know the risk

The use of shorting, derivatives, leverage and other structures also introduces different risk dynamics. Because hedge funds have the ability to short an asset, they carry a very different risk and return profile to traditional “long” assets. The risk from shorting means that you could lose more than 100% of your investment if proper risk control structures are not put in place.

Clearly, it is therefore vital for hedge funds to have very robust risk-management tools and procedures in place to mitigate the added complexities of their approach with respect to investment, operational and legal risk.

Diversify, diversify, diversify

If the risks are managed successfully, hedge funds offer the opportunity to improve portfolio returns while reducing the severity and frequency of losses, as well as providing access to new and otherwise unavailable return streams. And, like all investing, diversification suggests that hedge funds should always be a part of a larger portfolio, rather than the sole asset that an investor holds.

Geoff Blount is managing director of BayHill Capital.

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