We often talk about a diversified portfolio, and hedge funds could play an important part in that. We set out the basics, explaining what hedge funds could offer you and the main factors to consider on your investment journey.
With myths and misconceptions often surrounding them, we ask Emma Cory, Alternative Investment Specialist at HSBC Private Banking UK, to answer our key questions about hedge funds.
What are hedge funds?
“Hedge funds are alternative investment funds that trade across all asset classes. Pooling money and usually managed by institutional investors, they can reduce, eliminate, or (at times) amplify directional market risk,” explains Cory.
“Generally speaking, they are unconstrained in investment approach, and may use leverage, derivatives and short-selling to manage risks and achieve their investment objectives,” she continues.
What are the different types of hedge fund strategies?
There are, of course, a wide range of hedge fund strategies, and within each sub-strategy every hedge fund manager has a different approach.
Cory explains that there are six key hedge fund strategies. These are:
1. Equity long/short – which looks to profit from strong stock selection by investing in companies that are likely to outperform and selling short those that are considered overvalued. Shorts may help smooth out portfolio returns by minimising drawdowns, especially in severe market corrections.
2. Equity market neutral – which seeks to generate investment returns by taking matching long and short positions in different stocks. This is an all-weather investment due to its emphasis on eliminating market risk while preserving return potential. It can provide stability and diversification.
3. Event-driven – where investing focuses on trading a change in stock price due to an idiosyncratic corporate event that brings volatility to securities. Event-driven managers employ a wide range of different sub-strategies, e.g., activism or distressed securities or merger arbitrage. These strategies generate idiosyncratic returns, which are largely catalyst driven and uncorrelated to the market.
There are over 7,000 funds in the hedge fund universe with a high dispersion of returns. Hedge fund managers need to apply the best strategies for the current market environment. - Emma Cory, Alternative Investment Specialist at HSBC Private Banking UK
4. Credit strategies – which invests in credit and credit-linked fixed income securities. Strategies include credit long/short, distressed debt, structured credit, etc.
5. Global macro – where investment is often based on the link between macroeconomic factors and market developments. The manager often uses a combination of both directional and relative-value trading strategies to extract inefficiencies in asset prices. Robust portfolio construction techniques are combined with a strong risk discipline, such as tight stop loss limits, option hedging, as well as controlling for portfolio diversification. This can bring stable and consistent returns amid market volatility.
6. Trend following / CTAs (Commodity Trading Advisors) – which uses a variety of trading strategies to meet their investment objectives, including systematic trading and trend following.
Cory suggests that while each strategy offers benefits, you should consider diversifying across these and by manager investment styles.
“Clients should consider hedge funds as a meaningful portion of a well-diversified portfolio for a source of attractive uncorrelated returns and a downside cushion, and this is something we’re happy to talk through,” says Cory.
She adds: “However, at present we are overweighting this alternative asset class to enhance diversification at this late stage in the market cycle and potentially benefit from the volatility and rich opportunity set generated for hedge funds.”
What makes hedge funds an important part of a diversified portfolio?
Hedge funds capture opportunities not available to traditional long-only investments and benefit from techniques not easily replicated by individual investors, explains Cory.
“They can also provide an attractive risk return profile, with low volatility,” she continues.
Furthermore, hedge funds have the potential to provide sources of uncorrelated returns, reduce overall volatility and enhance total returns to your portfolio. Macro and CTA managers can be valuable diversifiers in an inflationary environment (now negatively correlated to fixed income).
What do investors need to know or be aware of when it comes to hedge funds?
There are two key things to be aware of, says Cory.
“As an alternative investment, hedge funds are classified as a non-mainstream pooled investment vehicle. They are considered high risk and complex investments and are not typically subject to the same levels of scrutiny and regulatory oversight as traditional investment funds.”
Second, to invest successfully in hedge funds, effective sourcing and thorough due diligence is key.
“There are over 7,000 funds in the hedge fund universe with a high dispersion of returns. Hedge fund managers need to apply the best strategies for the current market environment.”
“We work with clients to ensure they are aware of the complex investment and non-investment risks of hedge funds before investing, as well as the liquidity and associated high fees, so that together we can make the right choices.”
We work with clients to ensure they are aware of the complex investment and non-investment risks of hedge funds before investing, as well as the liquidity and associated high fees, so that together we can make the right choices. - Emma Cory, Alternative Investment Specialist at HSBC Private Banking UK
An investment in a Hedge Fund carries substantial risks. The risks inherent to an investment in Hedge Funds are of a nature and degree not typically encountered in investments in securities of companies listed on major securities markets worldwide. There can be no assurance that the Fund’s investment objective will be achieved and investment results may vary substantially over time. Investors incur the risk of losing all or part of their investment in the Fund.
Prospective investors should carefully consider whether an investment in shares is suitable for them in the light of their own circumstances and financial resources. Past performance does not predict future returns. The price of units or shares can go down as well as up and may be affected by changes in exchange rates. An investor may not receive back the amount invested. Such investments are illiquid, will not be listed on any exchange and should be regarded as fixed and long term.
Alternative investments are intended for sophisticated and experienced investors who are willing to bear the economic risks of the investment, including the possible loss of the principal amount invested. Alternative investments may use leverage and other speculative practices which increase the risk of investment loss. Alternative investments are not required to provide period pricing or valuation information to investors. Investors can expect fees to be higher than those of mutual funds. It is essential that investors read the prospectus of the Fund and acquaint themselves with the risks associated with an investment in the Fund, including the risks of the underlying investments.