Can hedge funds remove portfolio risk?

Featured product – defensive funds of hedge funds

But now along comes a different concept of the hedge fund, perhaps one that should have been the main selling point behind the hedging strategy all along: the defensive hedge fund.
The idea is, given that hedge funds use techniques that can neutralise the effect of falling markets (short selling, which we’ll explain in a minute), instead of seeing them as cash-cows to make you instantly rich(er), why not use hedging strategies as a way of protecting your money – defensive hedging?

What on earth do hedge funds do anyway?

Before we look at the actual funds under consideration, a quick lesson in what hedge funds do, and what short selling is, might be useful.

Normal investment funds simply buy likely-looking stocks in the hope that they will rise in value, and pay out chunky dividends. This is called being ‘long’ the market.
The thing that distinguishes hedge funds is that they are allowed to ‘short’ the market as well as to go ‘long’. This means that they are allowed to execute a neat little trick. If a stock market is falling, they can borrow stocks from specialised stock lending companies, sell the stock immediately at, say, $10, wait for the price of the stock to fall and buy the stock back at the lower price of, say, $7. They then hand the newly bought back stock to the lender at the agreed time and pocket the difference – $3 in this example.

This technique is called hedging because it hedges away any risk that a fund’s ‘long’ component runs from falling markets. Using this technique, along with other strategies like taking huge bets on currency movements, hedge funds in this mould were seen as big money-making opportunities, although pretty risky as well.

And that’s been the snag. Hedge funds just are inherently riskier than other funds, despite being able to work in falling markets, because they don’t just stop there. They have been in the business of making, and boasting about, massive returns, by engaging in what is effectively a high form of betting – currency speculation, as already mentioned. As any neophyte investor knows, you only get big returns by running commensurately greater risks. As a result, these funds have been open only to the rich, asking for initial stakes of many hundreds of thousands of dollars, or even millions. And fair enough, you might think.
But what if the perfectly respectable hedging technique – the risk-reducing bit – were emphasised instead of the ‘we’ll make you big bucks by punting’ aspect of hedge funds? And what if access to such a fund could be got for considerably less than previously?

The defence starts here

That, in a nutshell, is what funds of hedge funds have been selling themselves as for the last few years. Funds of hedge funds have usually been marketed as cheaper and slightly more risk-free ways into normal hedge funds. For a few tens of thousands of pounds instead of hundreds, they have invested in a range of underlying hedge funds. But the selling point has been the same: get access to higher than usual returns.

Absolute Fund Management, a UK-based fund of hedge funds, is now touting itself as a defensive fund of hedge funds manager. And the idea it is trying to put across is that investing in its range of hedge funds will be essentially a capital-preservation strategy, not necessarily a way of making big returns.

It makes at least surface sense. As a hedge fund manager you ought, at least, to be able to avoid a crushing on the downside. And Absolute is asking for a minimum investment of $100,000, which is hardly peanuts, but an easier way in than a straight hedge fund. But wait for the killer marketing point: up to one third of an investor’s portfolio should be invested in Absolute’s type of fund, according to the firm. Christopher Aldous, a director of Absolute, says that recent experience of tumbling markets ought to make investors sufficiently wary of straight equity and bond investment to shift that much of their portfolios into a market-safe fund of hedge funds like his.

Not everybody is convinced, though. Iain Jenkins, managing editor of InvestHedge, the specialist publication for the fund of hedge fund community, says that funds of funds have proved very effective at holding on to investor capital in the down markets of the past few years but many in the industry are now worrying about whether they have become too obsessed about risk control and have forgotten about generating returns.

“Funds of funds have been able to hang on to capital over the last few years. Very few of them lost any money and most made steady returns of around the risk-free rate in 2001 and 2002,” he says. “Most of their investors were very happy with the way funds of funds protected them but are now watching equity markets race away and wondering if they are going to get left behind. A number of funds of funds are now looking to inject more risk into their portfolios and a number are adding in leveraged vehicles.”

Absolute chooses the underlying hedge funds it invests in on the basis of a low risk, market-neutral approach. That means, says Aldous, that it will not invest in hedge funds using some of the dodgier strategies – so-called ‘global strategy’ funds, for instance, which are the ones that take huge bets on currency fluctuations. But while it might make some sense to have a biggish hedging component in your portfolio, surely nobody would be advised to hand over anything like that that proportion to a single company?

Suppose the most you would want to give to a single hedging firm is, say, 10–15 per cent of your portfolio. Since Absolute is asking for $100,000, that means their strategy – which, again, is not an implausible one – is effectively only available to someone with a million dollars or thereabouts to invest. Back to hedging being a rich man’s sport.