Hedge funds are here to stay

Hedge funds have been aggressively marketed as alternative investments which offer comprehensive protection in the event of a stock market crash.

Unfortunately, nothing could be further from the truth. These funds are managed to limit rather than eliminate losses in a falling market...

The local hedge fund industry is not currently regulated. Despite attempts to obtain regulation in terms of the Collective Investment Schemes Control Act the industry still relies on self-regulation.

Commenting on the release of two international hedge fund best practice reports, FinSource chief operating officer Veit Schuhen says "The global spotlight is turning to hedge funds. One of the areas under scrutiny is the valuation of complex illiquid financial instruments. In fact, while the debate around hedge fund regulation continues, the industry is in the meantime starting to self-regulate, as shown by the reports."

Schuhen believes that the South African hedge fund industry already follows most of the 'best practice' recommendations contained in these reports.

Defining hedge funds

Despite the amount of literature that exists on hedge funds it remains difficult to find a comprehensive definition for them. In the next few paragraphs we strive to answer the question: "What exactly is a hedge fund."

The best definition weve heard was provided at a round table discussion with a number of Old Mutual International investment managers. A hedge fund simply offers the "ability to short securities." This means that a hedge fund operates with a mandate to buy and sell conventional assets - and, where appropriate, to sell assets it does not own with a view to repurchase them at a lower price at some future date.

At a recent Nedgroup investment road show, Larry Jones, Chief Executive Officer of Nedgroup Investment Advisors (UK) provided some additional insights into the world of hedge funds. He advised that hedge funds were devised to generate asymmetric return profiles. A hedge fund manager strives to capture as much of the upside in the market, and as little of the downside as possible.

As an example of the effectiveness of hedging, Jones compared a graph of the MCSI World Index to a hypothetical 65/35 MCSI Index. Capturing 65% of any market improvements, and limiting losses to 35% of any market downturn allowed the hypothetical 65/35 MCSI Index to show significantly better returns.

Modelling the collective investment universe

Jones also pointed out that hedge funds should not be viewed as an asset class. Instead, such funds were a collection of individual investments (both long and short) selected from different asset classes. Hedge funds could include investments in equities, cash, bonds and property and comprise mixes of these assets in the same way as any other investment fund.

Hedge funds presently constitute a small portion of the global investment universe. There is approximately USD 70 trillion invested in traditional assets, with around USD 1.5 trillion in hedge funds. Jones believes the future investment environment will comprise mostly of absolute return funds, with hedge funds existing as a subset of this category.

It would be difficult to imagine the stock market without hedge funds. The principles applied in securing returns in this fashion are used everywhere in the world - and the amount of assets invested in hedge fund continues to grow.

Not everyone loves them

Of course, not everyone in the investment world is a fan of this type of investing. Warren Buffett is possibly the most admired stock market investor of the late 20th and early 21st centuries. His long-term value investment strategy, implemented through the Berkshire Hathaway company, has helped earn him a place as one of the worlds richest men. (He was recently knocked down to third place on the worlds rich list being replaced by a Mexican telecoms billionaire.)

When asked for his view on hedge funds, Buffett offered the following: "Hedge funds are a huge fad. You can pick any ten hedge funds and I'll bet that on average they will under perform the S&P over the next ten years. You can't create more money out of American business than the business itself creates; so most of these hedge funds will not be able to justify their outlandish fees over the long-term and they will disappear."

We will not question Buffetts view - but note that hedge funds remain popular today and will continue to feature in the investment environment.

Editor's thoughts:
Do you believe hedge funds have a place in a complete investment portfolio? Send your comments to [email protected].