Investing In Hedge Funds: 4 Key Things To Consider

Investing

Investing In Hedge Funds: 4 Key Things To Consider

With over 15,000 different hedge funds to choose from, how can investors determine which one is right for them?

Published on 18 October 2017

Hedge funds are a favourite with wealthy individuals, family offices, and institutional investors. These alternative investments utilise different types of strategies to maximise returns by taking advantage of market opportunities. Unlike the mutual fund industry, which is subject to strict regulatory norms, hedge funds are relatively free to operate as they like.

This flexibility allows them to invest in a wide range of securities, including sophisticated and high-risk instruments. The promise of elevated returns has led to a steep increase in the assets under management (AUM) of the hedge fund industry in recent years. Immediately after the global financial crisis of 2007-08, worldwide AUM stood at US$1.46 trillion. By November 2016, total hedge fund assets had risen to US$3.22 trillion.

But do hedge funds really deliver attractive returns? According to the figures released by Preqin, a provider of data for the alternative assets industry, the Preqin All-Strategies Hedge Fund benchmark returned 7.4% in 2016. While that’s not a spectacular rate of return, it can be considered to be satisfactory. In comparison, the industry’s performance in 2015 was dismal. The index gained only 2.03% in that year.

There is a wide variation in the performance of different hedge funds. In 2016, the top performer, Tribeca Global Natural Resources Fund – Class A made a net return of over 148%.

Selecting a fund to invest in can be difficult as there are over 15,000 of them. If you make the wrong choice, it could have a long-term impact on your portfolio. Most hedge funds do not allow redemptions before a certain period has elapsed ­– this could extend to a year or even more.

What are the key factors that you should consider when trying to decide which hedge fund to invest in? Here are four points that you should keep in mind.

01.

What is the investment philosophy of the fund?

A hedge fund is a unique investment option in many ways. Fund managers have a great amount of discretion in deploying your money. For this reason, it is important to find out as much as you can about their investment strategy before you actually commit yourself. Do some research and don’t make the mistake of taking an investment decision merely on the recommendation of a friend.

However, be aware that the amount of information about hedge funds that is available in the public domain is limited as their reporting requirements are not very stringent.

Before investing, you should have a detailed discussion with the hedge fund manager ensure you have a firm understanding of their strategy. If you are told that the instruments that the fund invests in are too complicated to explain, this should raise a red flag.

Warren Buffett, the legendary investment guru, has famously said, “Never invest in a business you cannot understand.” This rule should be applied to hedge fund investments as well.

Hedge funds regularly issue quarterly reports to their investors. Ask to see past reports as these will give you an idea about how the fund will invest your money.

02.

Evaluate the fund’s past performance

One reason that hedge funds are so popular is that they typically promise to make a profit for you when markets are down.

The first hedge fund was launched in 1949 by A.W. Jones & Co, which started the fund with US$100,000. It minimised the risk of holding high-potential stocks for the long-term by short selling other stocks. This evolved into the model that long-short hedge funds follow.

Hedge funds are usually evaluated on the basis of their absolute returns. The profits that they make are not compared with any benchmark. This is different from the manner in which the performance of mutual funds and certain other investments are judged.

When you are assessing a hedge fund’s performance, don’t look only at absolute returns. It is also important to determine the means that it has used to achieve these returns. Many hedge funds are highly leveraged. This can boost returns, but it can be classified as a high-risk strategy.

You also need to look out for “style drift.” At times, a fund may stray from its stated strategy to cash in on a market opportunity. Doing this may provide an immediate profit, but it is an indicator of the fund’s inability to adhere to its investment plan.

03.

Calculate the fund’s Sharpe ratio

A hedge fund may have made high returns in the past, but it could have used a risky strategy to meet its performance targets. When you are analysing a hedge fund’s performance, its Sharpe ratio will allow you to get an idea about its approach to risk.

The Sharpe ratio is essentially a measure of the risks that the fund took to achieve a certain return. Using this ratio will allow you to determine the extent to which a fund’s performance is associated with its risk-taking activities.

In other words, it is a good method to calculate a hedge fund’s risk-adjusted return. A higher Sharpe ratio indicates that the fund has been able to generate profits while controlling its level of risk.

A Sharpe ratio that is greater than 1 is considered to be acceptable. Remember that this is not the only metric that you should use to judge a hedge fund. But a high ratio will tell you that investors have been adequately compensated for the risk that they took on.

04.

You don’t need to pay “2 and 20”

The fee structure in the hedge fund industry is referred to as “2 and 20.” You will be charged 2% on assets regardless of the fund’s performance. Additionally, you will have to pay 20% of your profits.

While this is the traditional fee structure, there are variations. Rokos Capital, a UK-based firm, recently launched a fund that gave investors two fee options. In addition to the standard “2 and 20,” investors could pay a lower management fee of only 1%. But they would have to part with 30% of their profits.

However, both management fees and performance fees are dropping. Preqin reports that the hedge funds launched in 2016 charged an average of 1.51% as management fees. Performance fees have also fallen, but not by as great a margin. Of the funds launched in 2106, 73% charged 20%. The remaining levied performance fees of between 15% and 20%.

While in the case of some funds, high performance fees are justified, it is worth your while to try and negotiate these downwards. Opting for a fee structure that charges lower management fees and makes up by levying a higher performance fee could be preferable.

The bottom line

With thousands of hedge funds to choose from, deciding which one to invest in can be a complicated process. It is advisable to carry out a complete review before selecting a fund. But if you make the correct choice, you can earn a level of returns that is not possible with most other types of investments.

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