Personal Investment > Hedge Funds

What is a hedge fund?
There are different characteristics and investment strategies that define hedge funds. In general, a hedge fund seeks to deliver an "absolute" return independent of the directional move of equity, fixed income or cash markets. In considering whether a fund falls within these guidelines, MAS (Monetary Authority of Singapore) would consider, but not restricted to the following factors:
1. Strategies that use leverage, short-selling, arbitrage, derivatives and
2. Investment in non-mainstream asset classes (investments other than listed equities, bonds and cash)

Are hedge funds well established as an asset class?
Hedge Funds are considered an important part of the alternative investment asset class, where the returns are uncorrelated to the traditional financial markets. In the past, hedge funds were only available to institutional clients and very wealthy private banking individuals. Today, even conservative pension funds and endowment funds are allocating part of their portfolios in hedge funds. There are more than 5,000 funds operating globally with total assets managed at around US$500 billion.

What should I note about the risks of investing in hedge funds?
The risks involved in hedge funds investing and unit trusts investing are of a different nature than those offered by the traditional "long only" unit trusts. Like unit trusts, it is also possible to lose part or all of your capital investing in hedge funds.

Why are the risks of investing in hedge funds of a different nature compared to unit trusts?
Unit trusts have a "long-only" investment style, which means it is exposed to the market movements of the markets or sectors it invests in. However, hedge funds are investment strategy based and it may exploit inefficiencies in the markets or makes directional bets (both up and down) and not heavily dependent on market moves.

What are some of the financial instruments a hedge fund can invest?
Besides the traditional equities and bonds, a hedge fund uses derivatives like futures and options to execute its strategies.

How do hedge funds compare with unit trusts?

Why are hedge funds less transparent with respect to information than traditional unit trusts?
Hedge funds are manager skill based, which means that there is a certain level of proprietary knowledge involved in the selection and methods of the hedge fund. Furthermore, most hedge funds are not regulated, which means that they may not be obliged to disclose their holdings completely or in part.

Why are hedge funds called absolute return strategies?
Hedge funds focus on generating an absolute return rather than comparing with a specific index. For example, if the benchmark market index like Dow Jones Industrial Average falls 10%, a unit trust is said to outperform the index even though it has a negative return, albeit a smaller one, e.g. -5%. However, a hedge fund would be aiming at least a target return, say 5% for the year.

What are the main benefits of hedge funds?
Hedge Funds as an asset class has historically offered to the investor equity type of returns at typically half the volatility offered by equities. Hedge funds are also lowly correlated to financial markets that make them attractive investments for portfolio diversification.

According to the CSFB/ Tremont Hedge Fund index, the 3 year average returns of the index is about 9-10% while the S&P 500 and MSCI World US$ indices have both returned an average of a negative 7-8% over the same period.

What is correlation and why is it important?
Correlation measures the degree of linear association between two events. For example, when the US markets rise, the European markets also have the tendency to rise in tandem as well. This is an example of positive correlation. In times of global political instability, financial markets would typically fall while gold prices would rise. This is an example of negative correlation. If your investment assets have low correlation with each other, the price falls in some assets would be offset by the gains made in other assets – leading to a less volatile portfolio return (i.e. less risk). In general, hedge funds typically showed downside protection by having only slightly negative returns or flat returns when the financial markets are bearish.

Are hedge funds risky?
This is a common question, no thanks to the negative publicity created by the failure of LTCM (Long Term Capital Management). However, it is worth emphasizing that LTCM is essentially a single manager hedge fund that is opened to institutions only. There was a general lack of transparency of the hedge fund and there was an extremely high level of leverage involved, magnifying the risk exposures.
It is possible to lose part or all of your capital by being invested in hedge funds. However, it is worthwhile to note that hedge funds in general have lower downside volatility compared to stocks and investing in a fund of hedge funds structure can mitigate the failure of an individual hedge fund.

Why have you used the CSFB/Tremont Hedge Fund index?
As a proxy for the performance of hedge funds in general, we have used the CSFB/Tremont Hedge Fund Index as a guide. The index is one of the more popular and established hedge fund indices. To date, it consists of 2,600 hedge funds managing at least US$10 million each. For more information, please refer to www.hedgeindex.com

Is a hedge fund similar to a unit trust?
It is similar in the sense that they are both pooled investment vehicles where the fund manager manages the fund and a management fee is levied on the size of the assets managed.

What are some of the non-mainstream investment strategies?
There are three main categories of hedge funds. These are Relative Value, Event Driven and Opportunistic.

Relative Value strategies seek to profit from pricing differences due to market inefficiencies. Examples of such strategies are: Fixed Income Arbitrage (bonds), Equity Market Neutral (equities) or Convertible Arbitrage (convertible bonds).

Event Driven strategies are executed when there is some corporate event like a takeover or merger (Risk Arbitrage) or a bond default due to a company’s bankruptcy (Distressed Securities).

Opportunistic strategies are directional bets in currencies and commoditiy futures (Managed Futures) and bonds or equities in anticipation of certain broad market movements (Global Macro). On a micro level by selecting specific stocks, this can be found in Equity Long/Short and Emerging Markets Strategies.

Why are hedge funds important investments in the future?
Generally, the macro trend of equities has been a 15-20 year cycle since the beginning of the last century. The last bull market which can be said to have started in the early 80s, have run its course cumulating in the peak of 2000. The next phase is most likely to see a more bearish overall tone in equities. As a result, funds that can go short and execute non-mainstream investment strategies can optimize the opportunities that the increasing efficient market may offer.

How much should I put in hedge funds?
As hedge funds lack liquidity relative to unit trusts due to positions that have been taken to execute the investment strategy, hedge funds should form a part of your overall investment portfolio. A typical portfolio would contain 10-20% hedge funds. You should consider hedge funds investing in the light of your circumstances, financial resources and entire investment program. You are also advised to approach your financial planner for assistance.

What is a Fund of Hedge Funds?
A fund of hedge funds is a portfolio in which a professional manager will allocate capital across a range of hedge funds, which in turn may invest in a wide range if investment markets using differing techniques. The manager will be responsible for deciding which investment strategies should be invested in as well as selection of the most appropriate hedge funds for the chosen strategy.

The strategy is to optimise the returns and correlation offered by the different hedge funds following different strategies and managed by different fund managers. As the different investment strategies perform differently in different time periods, there is diversification across the different investment strategies. Furthermore, there is also diversification across hedge fund managers who may have different risk profiles, orientation and focus in the strategy they follow. A fund of hedge funds also mitigates the negative effects through diversification in the event that a hedge fund fails. The managers of the fund of hedge funds are also able to enforce monitoring and reallocation of hedge funds, further reducing hedge fund failure risk. Fund of hedge funds is an excellent way to get started in hedge funds due to its risk reducing diversified approach that is its key advantage.

Can I invest directly in the individual hedge funds directly instead?
It may not always be possible because some hedge funds may be closed to individuals for further investment. Furthermore, there may be a higher minimum investment quantum involved. Other disadvantages are a higher risk approach to investing as your fund would not be optimally allocated across the hedge fund managers due to lack of transparency and the relative sophistication of the investment allocation and monitoring process.

What is the minimum investment amount?
For a Singapore registered retail hedge fund, the minimum are as follows:

For offshore funds, the minimum is typically US$20,000 to US$100,000 and accredited investor requirements apply. To be a accredited investor, you need to have S$300,000 in annual net income and a net worth of at least S$2 million.

What kinds of fees are involved?
Typically, a hedge fund has 3 kinds of fees.

• Sales charge
(generally 5%) is the front-end load or commission that is charged on the investment amount. The sales charge is one-time only. This is similar to the sales charge of unit trusts.
• Management fee
(varies, around 2%) is charged on an annual basis and imputed into the NAV (Net Asset Value) of the fund. This is similar to the management fee of unit trusts.
• Performance fee
(varies, around 10-20% above benchmark) is charged on an annual basis and imputed into the NAV (Net Asset Value) of the fund. The benchmark can be simply the zero return line or a benchmark like the LIBOR rate. Performance fees are charged on a high water mark which means investors are only charged for excess returns with reference to the previous high. Unit trusts do not charge a performance fee.

How liquid are hedge funds?
Hedge funds typically allow investment and valuation on a monthly basis or quarterly basis. For Singapore registered hedge funds, MAS guidelines stipulate one regular dealing day per quarter. Redemption of funds usually requires a notice period and MAS guidelines states that redemption proceeds must be paid to the end investor within 95 days from the dealing day the redemption request is accepted.

What are the implications if the valuation of the hedge fund is done on a less frequent basis?
Redemption price may be affected by the fluctuations in value of the underlying investments from the time a redemption request is submitted and the date the redemption price is determined.