Hedge fund: What is it all about, and should you hold it in your portfolio? A hedge fund can take on the simple form of a unit trust, in which various securities are traded

Hedge funds are supposed to factor in exactly what the name suggests – hedge a portfolio against a certain unknown and/or undesired future outcome. Hedge funds are normal unit trust funds, with a specific mandate in how the fund is being managed, and the type of securities they hold.

The general investor tends to have a negative bias towards hedge funds, in the sense that they might be over-complicated, not regulated, and the list goes on. This however is not the case. Hedge funds perform a very particular function within a diversified portfolio and should most definitely not be thrown out the window.

What exactly is a hedge fund?

A hedge fund can take on the simple form of a unit trust, in which various securities are traded. A hedge fund, however, has a very wide mandate relative to a normal unit trust fund that simply buys stocks based on technical- and fundamental analysis and sits on these holdings for a certain period to outperform the general market and beat inflation.

Hedge funds implement a wide range of securities being traded, risk management techniques etc. For example, a hedge fund can implement strategies such as short selling (which is the opposite of being long on a stock), pair trades, and derivatives to name a few. These strategies enable hedge funds to generate superior returns in bear markets and declining economic environments and may generate great real returns irrespective of the general market direction.

A long call is a call option that is betting that the underlying stock is going to increase in value before its expiration date.

A short call is an options position taken as a trading strategy when a trader believes that the price of the asset underlying the option will drop.

Hedge fund managers have a ‘bigger toolbox’ at their disposal and have more ways to manage risk and returns than simply trying to hold the right assets/shares to generate superior returns. By nature, hedge funds are more active-managed funds than standard equity funds, and hedge fund managers will trade and change their positions in the fund on a more frequent basis. An important factor to remember is that hedge funds are not benchmarked cognisant and these funds typically seek absolute returns.

How safe are hedge funds?

As mentioned above, hedge funds take on the same structure as unit trust funds – which are considered safe investment options. South Africa became the first country globally to put in place comprehensive regulations for hedge fund products in April 2015. Initially, these funds got a bad stigma to them as they were not regulated, but the landscape changed drastically over the last 10+ years. Because of these changes and regulations, it is now an option that should be considered as part of a diversified portfolio, especially in bear market cycles.

Investors need to remember, there is a difference between ‘safe’ and ‘volatile’ – do not confuse these two with each other. By nature, most hedge funds will experience a higher degree of volatility, but this does not imply that a hedge fund is not a safe investment case. In fact, in bear markets (current 2022 market as an example), hedge funds tend to strongly outperform the general market and most asset classes on average (and yes – including cryptos!)

Special considerations to hedge funds

As discussed above, hedge funds operate with a higher mandate than unit trust funds and therefore use more tools and options within the fund. Due to this, the return profiles of hedge funds can differ significantly from normal unit trusts and investors need to be clear on the objective of the hedge funds. Remember, not all hedge funds have the same mandates – each fund manager will manage the fund based on their research and views. The wider the mandates and ‘toolbox’ used by the fund manager; the more risk exposures are being built into the fund. It is exactly these risks the fund is exposed to that drive the opportunity for superior returns in volatile and negative markets.

Hedge funds can correlate with more traditional investments in the short term and require the investor to be able to sit tight through various market cycles. Below is a great example of what hedge funds try to achieve in especially negative market cycles. Hedge funds tend to have a negative correlation compared to the general equity market, which is the exact reason why hedge funds should be strongly considered as a part of a diversified portfolio.

Hedge funds provide a different depth of diversification outside merely asset class or geographic diversification. This provides diversification in terms of how the underlying holdings are bought and held. Therefore, hedge funds (when used as a part of your portfolio) actually bring down the level of volatility and risk in the underlying portfolio by building in uncorrelated returns in different market cycles.

Fund capacity in hedge funds also tends to be smaller due to the active management style. This also raises slightly higher fund manager fees due to the amount of time and effort fund managers spend managing these funds.

How do you select the best possible hedge fund?

Selecting the best possible hedge fund to build into a portfolio is no easy task, therefore there is a couple of things to delve into. Choosing a manager based on their past track record is important, but there are other factors to consider:

Investment objective:

What is the manager trying to achieve?

Lower volatility or enhanced return?

Decreased correlation?

Team:

What are the management team’s makeup, experience, and culture?

Risk management:

Historical gross, net exposure, and drawdowns?

Ability to adjust exposure? (Flexibility of the fund)

Operations:

Does the fund have sound operational infrastructure backed by a dedicated support team? – Moneyweb

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