What exactly are Hedge Funds, how do they work
and how have they performed?
By default, a hedge fund is normally classified
as an investment vehicle that does not fall
into the usual categories of historical portfolio
options or strategies. While many believe
they tend to be higher risk investments, most
hedge fund managers follow a strategy of hedging
the risk which, if properly implemented, moves
this vehicle into the consistent and stable
returns classification.
To emphasize the consistency and stability
goals, a number of hedge funds are targeted
to deliver what is termed an “absolute
return.” Implementing a variety of complex
strategies, these funds are projected to offer
profit in both rising and falling markets.
Unlike normal equity and bond funds, usually
rated on their performance, good or bad, as
compared against a variety of industry indices,
hedge funds attempt to generate a positive
return under both market conditions. Hence,
a well managed hedge fund should still perform
acceptably regardless of the current direction
of the world’s stock markets. Unlike
traditional fund managers who, in falling
markets, must consider liquidating some of
their portfolio and moving into a cash (or
cash equivalents) position, the hedge fund
manager often has other options to generate
positive returns.
It should be understood, however, that most
hedge fund managers face less strenuous regulation
than normal and usual funds. Having this flexibility
comes with a potential downside as their portfolio
activities are not as “transparent”
as other fund manager’s moves, by definition,
must be. Using alternate investment strategies
may also pose a timing problem regarding one’s
access to money as many of these funds operate
on a quarterly basis.
Further, it is becoming a regular practice
to compensate hedge fund managers on an incentive
basis rather than a fixed percentage of assets
in a portfolio. Using this approach, both
client and manager win together if fund performance
approximates strategic goals. Sources indicate
that using an incentive-based compensation
plan often attracts managers with higher skills
and experience using a wider variety of strategic
options to hedge funds.
But the intrinsic question remains: Can clients
truly make money when the world’s stock
markets are in decline? There is no single
answer since performance, as always, depends
on the assets being purchased and the effectiveness
of the hedge fund’s strategic alternatives
in a down market. A strategic plan for achieving
“absolute return” in one type
of declining market may be successful while
a different approach could easily bring about
a negative result in that same market. On
paper, a manager using a conservative strategic
alternative (such as long/short strategies)
can still be successful in a declining market
because of his/her ability to repurchase the
same assets inexpensively.
Recent historical data shows that this type
of fund has generated returns roughly about
twice the recorded rate of return of the world’s
stock markets, when their data is pooled.
While this record is positive, one must remember
that the majority of asset types also performed
consistently well over this period. There
were no serious declining market conditions
to severely test the projected performance
of these advanced strategic alternatives.
Using an “event driven” strategy
(foreign government instability or philosophy,
corporate mergers, etc.) rather than the classic
“performance driven” approach,
some hedge fund managers hope to take advantage
of pricing moves that result from these events.
While difficult to accurately compare results
with traditional equity and bond markets,
statistics indicate these funds may perform
higher during strong market conditions. This
data does not, however, verify the effectiveness
of this strategy in a declining market.
While general return data indicates overall
positive performance. Certainly, having recorded
no definitive negative results is a good indicator
