Hedge funds 101: Study and plan carefully

Hedge funds 101: Study and plan carefully

Hedge funds have always been the preserve of the wealthy but new types of products are giving the rest of us access to the investing strategies these financial top guns employ.

Investment firms are developing these products on the back of increasing demand from average investors looking for alternative places to park their cash.

Take Franklin Templeton. It received approval to lower its minimum investment amount for its Franklin K2 Alternative Strategies Fund, a multi-manager offshore liquid alternative fund, from $100,000 to $1,000 in February.

The fund cannot be referred to as a hedge fund, but it "gives investors access to a group of unaffiliated, institutional-quality hedge fund managers with strong track records of delivering attractive risk-adjusted returns over multiple market cycles", the firm says.

Mr Brian Tan, fund manager at Pilgrim Partners Asia, which started a macro hedge fund in May 2010, says that in the earlier days, funds mostly took only long positions, which involve holding a stock and expecting its price to rise.

"Investors wanted more investment flexibility when markets dropped, so they started funds which could hedge their risk, so the term hedge fund came about."

He says the term now refers to a broad category of funds that have a flexible mandate to invest in multiple asset classes. They can also take both long positions or short positions, where you sell a stock hoping the price falls.

"Some can also invest in illiquid assets and some hedge funds work with very narrow specific strategies like betting only on merger arbitrage situations. The main idea is to make money regardless of market conditions. That is easier said than done," adds Mr Tan.

Before putting your money in investments that are exposed to hedge funds, you need to understand the basics of these funds so that you can make an informed decision.

HOW HEDGE FUNDS WORK

Such funds aim to provide returns not correlated to the traditional stock and bond markets, says Mr Alvin Lee, Maybank's head of regional wealth management.

"Hedge funds also aim to achieve positive returns regardless of how the market moves," he added.

Keen on hedge funds? Study and plan carefully

A hedge fund uses derivatives like futures and options as well as the usual publicly traded stocks and bonds.

Professor of finance Melvyn Teo from Singapore Management University's Lee Kong Chian School of Business adds that a hedge fund gives the manager a wide range of investment flexibility.

"Managers typically can short- sell, take on leverage and trade in derivatives. Hedge funds often charge a management fee of about 2 per cent as well as a performance fee of about 20 per cent," he says.

"The performance fee helps align the interest of the manager with those of his investors."

Short-selling refers to selling securities you do not own and are hoping to buy back later at a lower price. You are making a call that prices on a particular security will fall.

Investment firm Franklin Templeton says hedge fund managers aim to earn returns from two sources, known as the alpha and beta.

The Financial Times describes the alpha as "a measure of a stock's expected return that cannot be attributed to overall market volatility".

"In other words, the amount the price of a stock is likely to rise or fall (is) due to reasons specific to the company rather than due to the market as a whole."

Franklin Templeton says beta is used to measure market risk, and is the return you get from the market.

"The alpha will be the extra return the fund manager can generate, and hedge funds tend to focus more on the alpha than the beta. A traditional fund manager focuses more on the beta."

HEDGE FUND MISCONCEPTIONS

The popular misconception about hedge funds is that they are risky as fund managers make huge directional bets on stocks, currencies, bonds, commodities and gold and other products, while using a lot of leverage, says Maybank's Mr Lee.

"In reality, most of the hedge funds only use derivatives for hedging to protect the downside, which explains how the name 'hedge funds' came about in the first place."

He added that another popular misconception about hedge funds is that they are illiquid, meaning you could have trouble selling your holdings.

While some of them are, a group of liquid alternatives have been created - under what is known as the Undertakings for the Collective Investment of Transferable Securities (UCITS) framework - as a response to the increased focus on liquidity and regulatory aspects for hedge funds, he added.

"The UCITS standards require at least bi-weekly liquidity and are increasingly used by hedge fund managers to market their funds to investors worldwide."

INTERESTED IN A HEDGE FUND?

Pilgrim's Mr Tan says the Monetary Authority of Singapore requires individual investors in hedge funds to be accredited investors. This means you need a net worth of at least $2 million or an annual income of at least $300,000.

He says: "We would recommend that investors plan their allocation to hedge funds carefully as these are not the run-of-the-mill investments where you can set and forget. You will need to choose a strategy that you're comfortable with and can understand. Definitely only invest with money that you can put aside for the long term."

Mr Robb Fipp, head of business development Asia for UBS Asset Management's hedge fund unit UBS O'Connor, adds that before investing in a hedge fund, investors should discuss their risk and return appetite with an investment adviser.

"It is also important to consider one's liquidity needs in the near and longer term. Hedge funds - especially non-UCITS set-up - usually do not offer daily or weekly liquidity. It is not uncommon for hedge funds to have quarterly or even longer redemption terms."

Pilgrim's Mr Tan also says hedge fund fees will vary but they should not be the primary consideration, as some successful hedge funds charge a 3 per cent management fee and a 30 per cent performance fee. "They produce returns well in excess of cheaper hedge funds. You generally get what you pay for."

He adds that there has been no particular type of hedge fund strategy that has done well since the beginning of this year.

Singapore-based data provider Eurekahedge noted hedge funds are down 1.27 per cent as at February, with total assets under management declining by US$20.1 billion (S$27 billion).

However, some have performed better, like the Pilgrim Growth and Income Fund, which saw a return of 7.53 per cent in February.

Mr Tan adds: "Our fund was lifted by the fund's hedges as markets took a tumble and our view that gold was undervalued was realised. Some of our stock picks went up after buying more at the market lows in January and February. All in all, this not a bad start to the year."

Mr Kelvin Tan, head of investment funds at DBS Private Bank, said an easy way to begin investing in this area is to invest in a fund of hedge funds (FOHF), which are investment vehicles that put money into a variety of hedge funds.

"From there, investors might look at either investing in various hedge fund strategies - or 'multi- strategy' - or in a diversified portfolio of higher-quality managers or 'multi-manager' portfolios.

"FOHFs usually have lower barriers to entry in terms of investment size and are more diversified."

Prof Teo, who is also the associate dean of research, says the benefit of investing in a fund of funds - which invests in a pool of single-manager hedge funds - is that the minimum investments are usually lower, ranging from US$10,000 to US$100,000.

The downside is an additional layer of fees, and he notes that a fund of funds typically charges a management fee of about 1 per cent and a performance fee of about 5 per cent.

WHAT TO LOOK OUT FOR

Prof Teo says the manager of the hedge fund should be investing a substantial portion of his net worth in the fund, "so that his incentives are better aligned with those of his investors".

He notes the fund should have independent service providers for roles such as the administrator, prime broker and custodian, so that you can verify the holdings of the fund with an independent party.

DBS' Mr Tan notes that more liquid hedge funds have been coming to market and some are even available to retail investors.

He says that in the United States, those funds should comply with what is known as the 40 Act, and in Europe, with the UCITs directive. "However, everything comes with a trade-off. With greater liquidity, there are also more restrictions on strategies and instruments that the fund can use."

Like any other investment, investors should thoroughly understand and become comfortable with both the investment and operational sides of a prospective hedge fund, says Mr Fipp of UBS O'Connor.

He advises investors to note the longevity of a fund and the experience of its managers.

"Recent studies have suggested that more than 75 per cent of all invested assets in hedge funds globally are allocated to funds which have been managing assets for at least 10 years or more," he adds.

Depending on your risk appetite and possibly the advice of your financial adviser, he says, you could evaluate the exposure to market movements and level of transparency.

Prof Teo says the liquidity a fund provides to its investors via its redemption terms should be in line with the liquidity of their underlying assets.

"So a fund that is invested in illiquid, difficult-to-trade, hard-to- price distressed assets should not be allowing investors to redeem every month with a one month's redemption notice," he notes.

"It will be more sensible for such funds to lock investor capital up for the first one to three years and to only allow for redemptions after significant advance notice is given."

You should also evaluate the returns of the fund relative to the risk that the fund takes, he adds. "A simple way to do so is to examine the fund's Sharpe ratio, which is simply the ratio of the fund returns - in excess of the risk-free rate - over the standard deviation of those returns.

"To understand hedge fund risk better, investors can look at other metrics such as the peak-to-trough drawdown, as well as how the reported fund returns vary with those of traditional asset classes such as stocks and bonds."


This article was first published on April 10, 2016.
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