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 hedge fund performance data indicates overall positive performance. Certainly, having recorded no definitive negative results is a good indicator