Hedge Funds, an Asset Class Insight
Like the Absolute Return funds previously featured, Hedge funds can utilise numerous sophisticated investment strategies, which can make them a useful tool to consider when constructing a portfolio; correlations with traditional asset classes can often be low or even negative. This leads to the potential for gains to be made by high quality hedge fund managers when traditional financial assets might be facing difficult times.
However, because of the complexity of this asset class, many investors – and many financial advisers – may avoid this sector, due to unfamiliarity. We feel this need not be the case as this asset class can provide useful benefits to a portfolio. Hedge fund strategies include:
• Long/short strategies
Buying (going long on) securities predicted to increase in value whilst selling (going short on) securities predicted to either decrease in value or underperform the longs. The aim is for the manager to profit from the difference (on being correct), making a positive return regardless of whether the stock market (or any other market) may be going up or down. Depending on the proportions of all long/short trades, the fund can then have a positive, negative, or neutral exposure to the stock market, which will depend on the manager’s view, approach, and market conditions. Conducted successfully, this can result in a returns profile that is unrelated to the often turbulent ups and downs of global stock markets, and potentially a much smoother return payoff too.
• Market Neutral Strategies
As above, if a fund manager was 50% long and 50% short on a market, for example, it could be possible to be neutral to market movements. This is achieved by constructing a portfolio with a Market Beta of 0. Beta reflects a portfolio’s sensitivity to move up and down with the overall stock market.
• Arbitrage Strategies
In order to take advantage of market anomalies. For example, if an investor could buy a physical commodity in London for £5 and sell it in Paris for £10, a profit of £5 could be made per unit (excluding costs such as transportation). Many complex ways exist to try to squeeze out profits from pricing differentials.
• Macro Strategies
Investing across numerous asset types, including derivatives, in an attempt to benefit from macroeconomic changes, such as an increase in interest rates or currency movements.
Other strategies also include buying distressed securities, leveraged strategies, and short-only strategies.
It should be noted that although risk management is a very important component in a Hedge Fund’s investment strategy, Hedge funds can be ‘geared’, meaning they can borrow money and invest these proceeds. This means that total gross exposure can be over 100% of the fund’s assets, as it is possible to invest this plus borrowed capital. For this reason, investing in Hedge Funds does entail additional risks.
The chart from FE Analytics portrays the performance of a fund we class as a Hedge Fund within the Fiducia portfolios, against MSCI World, a benchmark for global equity markets, during 2015 (see Graph 1 left).
The highlighted period portrays a large potential benefit of holding this type of asset. It can be seen that during the period between August and November 2015 (and in many smaller time horizons before), the Hedge Fund exhibited negative Beta to Equity markets; that is, the fund moved in the opposite direction to Equity markets, critically when stock markets fell. This served to be useful during this period, as in August 2015 stock markets declined sharply, as noted by the yellow line spiking down.
Taking opposing positions, or hedging a position, can therefore reduce portfolio losses, albeit at the cost of also limiting potential gains in rising markets. A skilled manager will be able to take a significant portion of gains whilst also limiting loss potential – in other words, using their skill to hedge at the right time or in the right proportion.
To serve as an example, Graph 2 (right) shows a hedged portfolio, consisting of a 50/50 split (as of the start of the period, at the beginning of 2015) between the Hedge Fund and a Global Equity fund, Odey Allegra Developed Markets.
In Graph 2 it can be seen that the formed portfolio, denoted by the blue line (B), exhibits a far smoother and consistent returns profile, showing the benefit of diversifying into hedge funds alongside equity investments.
It is notable that the blue line (B) does not get as caught up in severe volatile up and down swings; the losses made by one asset class are partly covered by the gains made in the other.
Furthermore, the blue line does not lie perfectly in the middle of the grey and yellow lines – the progress of the blue line is slightly superior to the simple average of the two funds (the midpoint between lines A and C). In other words, diversifying into Hedge Funds in this example has created a superior risk/return profile, as well as a higher overall level of returns than investing without the hedge fund.
Introducing additional asset classes, with varying degrees of covariance and correlation, can assist with constructing portfolios that are much less subject to pricing swings (volatility) within a single asset class. In turn, this should translate into lower overall portfolio risk due to the various offsetting risk dimensions within the overall portfolio. As a further plus, introducing alternative asset classes adds the potential to benefit from additional sources of alpha returns, with the intention of boosting overall portfolio performance.
Our next update will feature another asset class.
If you would like to know more about how we as Financial Advisers can help you with your Investments then visit the Investment Management section of our website: Investment Management or send us email at: firstname.lastname@example.org
The information contained in our website is for guidance only and does not constitute advice which should be sought before taking any action. The information is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly, no responsibility can be assumed by Fiducia Wealth Management Limited, or any associated companies or persons, its officers or its employees, for any loss occurred in connection with the content hereof and any such action. Professional financial advice is recommended for every case.
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