Until recently, only institutional investors such as retirement funds were allowed to invest in hedge funds, but recent legislation changes mean that all investors can now consider hedge funds as part of a balanced portfolio.
While no investment type can guarantee returns, particularly over the short term, hedge funds are great diversification tools and offer advantages that other investments cannot.
The South African retail hedge fund market (the hedge funds that are available to the public) officially opened in February with the launch of two products from Novare.
So, what does a person who is considering a hedge fund investment for the first time need to know about these products?
Hedge Funds vs Unit Trusts
“All the money invested in a hedge fund goes into a pool, with a fund manager deciding which assets to invest in,” explains Eugene Visagie, Head of Hedge Fund Investments at Novare Investments.
“Just as is the case with the unit trusts that represent the majority of people’s retirement investments, fund managers for the most part invest in stocks or bonds. However, hedge funds have other tools at their disposal that unit trusts do not. Probably the most significant of these is that hedge funds are able to make money on an asset even if it declines in value.”
“This approach is called taking a short position on an asset. To use a simple example, taking a short position is like borrowing a set of clubs from another person with the undertaking of returning them after a while.
“Because you think that the price of the clubs is about to go down, you sell it to a third person. The price then goes down and you buy it for a cheaper price. You then give the clubs back to the person who lent it to you and pay a small fee for the privilege of borrowing it, keeping the rest of the profits that you made from the difference in the price of the clubs you borrowed and the new ones you bought.”
Short Position vs Long Position
In contrast to short positions, long positions are the normal asset investments most of us are familiar with, where you purchase items such as shares in the hope that their price will go up in the future. Hedge funds can consist of both long and short positions, to give investors the best of both worlds.
“In a hedge fund, the fund manager looks for stocks that are overvalued to take a short position on, and stocks that are undervalued to take a long position on. Together, they make up the hedge fund portfolio,” explains Visagie.
Because of the mix between long and short positions, the price movements of hedge funds are usually independent from the movement of the general financial market, which is why hedge funds are valued as an important component of a well-diversified portfolio.
Lower Fees, Better Investment Terms
“Another advantage of hedge funds is that their size allows them to negotiate better investment terms, which can include lower fees,” says Visagie. “As a result, investors benefit from the economies of scale inherent in a hedge fund.”
Also, there are many different hedge funds to suit the many different personalities and goals of investors. Each fund manager has a different mandate, covering the entire spectrum from very risky to very conservative. However, the new regulations ensure that the hedge funds that have been made available to the public will not take on excessive risk.
In addition to their approach to risk, fund managers are also bound by other conditions in their mandates to tailor the hedge fund to a particular investor need. Some might look more towards long or short positions; others only at particular industries, like mining; and others only at particular markets, like Asia.
A Fund Of Hedge Funds
With so many different hedge funds to choose from, the first-time investor might not know where to start to evaluate the right investment, which is why Visagie recommends looking at a fund of hedge funds.
“A fund of hedge funds is a hedge fund that is made up of other hedge funds. You therefore get the benefit of a combination of the different strategies from a couple of fund managers, all rolled into one.”
Another trait of hedge funds that distinguishes them from other investments is their ability to make leveraged investments.
Leveraging means that growth in an investment is multiplied, sometimes by as much ten times the original percentage. However, it also means that losses are multiplied in the same way.
“I would not advise investors to invest in leveraged hedge funds from the start, as they can be very risky,” advises Visagie. “Later, when you have built up a solid portfolio, you could allocate a small percentage to more risky investments that have the potential to maximise returns.”