This fact sheet provides additional information to help with understanding the investment, tax and other financial planning concepts that we have discussed with you or included in your Statement of Advice.
Please contact your adviser if there is any aspect on which you need further information or clarification.
What are Hedge Funds?
Hedge funds are pooled investment vehicles that utilise non-traditional investment strategies or asset classes to generate returns.
Hedge fund investment objectives vary from fund to fund, with strategies typically unconstrained by benchmarks. A key aspect is that hedge funds concentrate on generating returns independently of the market environment – they are thus an alternative investment with a low correlation with traditional investment categories.
Since they are less regulated than conventional funds, hedge fund managers can use leverage, short selling and derivatives in the strategies they employ.
Hedge funds have traditionally been associated with offshore jurisdictions and low levels of regulation and oversight. However, following the Global Financial Crisis, some hedge fund strategies are now available, albeit slightly modified for regulatory purposes, in more traditional fund structures and jurisdictions.
Common Hedge Fund Strategies
The risks involved in hedge fund investment depend on the specific strategy employed by the hedge fund manager. The financial instruments and amount of leverage a hedge fund manager employs in a particular strategy also differs from fund to fund.
Equity Hedge or Long/Short Equity and certain Event-Driven strategies tend to be more correlated with risky assets while Global Macro and CTA strategies show lower correlations (positive in bull markets and low to negative in bear markets). Relative value is relatively uncorrelated but prone to higher correlations during liquidity events.
In order of lower to higher expected return/volatility:
- Relative Value (RV)
- Event-Driven
- Long / Short Equity
- Global Macro
- Commodity - Trading Advisors (CTA)
Relative Value
Profits are realised based on price differences between markets and not on a market expectation itself.
There are four main types:
- Convertible arbitrage, where the manager takes advantage of the price difference between an implicit option with the underlying value.
- Fixed-income arbitrage, where the manager takes advantage of price differences between fixed income instruments
- Capital structure arbitrage, where the manager takes advantage of differences between assets and foreign capital of a company
- Equity market neutral where the manager uses differences in stock price by balance long and short positions in market sectors.
Event-Driven
Funds realise profits from share price fluctuations caused by single events in a company's lifecycle.
There are three main types:
- Merger arbitrage - takeover or merger of companies
- distressed securities - companies in challenging situations
- Special situations - special situations such as spin-offs or buyouts
Long / Short Equity
The fund invests according to its expectations of the future development of stock prices. This strategy is, therefore, a directional approach.
There are three main types:
- Equity-hedge - The equity portfolio is hedged using options/derivatives.
- Equity non-hedge - Similar to common investment funds but managers can make use of external financing (leverage).
- Short selling - Incorporates an opportunity for the fund manager to make investments on falling market expectations.
Global Macro
Fund investments are made based on forecasts of changes in the macroeconomic environment,, commonly expressed in exchange rates and interest rates.
Fund managers invest in different markets such as currencies or commodities using a wide range of financial instruments (e.g. futures, swaps, options).
Commodity-Trading Advisors (CTA)
CTA hedge fund managers trade exchange-traded futures contracts on a variety of underlying assets, including commodities, equities, and currencies, as well as indices and interest rates. Due to their use of futures and high activity level, CTA strategies are also known as 'managed futures' strategies.
CTA trading may be systematic, based on pre-set rules to anticipate future price movements, or discretionary. A discretionary trading strategy involves investment decisions based on the discretion and expertise of the manager.
Common Hedge Fund Structures
There are different possibilities for investing in hedge funds.
- Direct investment in offshore hedge fund
- Direct investment in locally registered hedge fund
- Investment in exchange-traded hedge fund
- Investment in a fund of hedge funds
Direct investment in offshore hedge fund
Professional/institutional/accredited or qualified investors can invest directly in the fund. The sale of off-shore funds is often restricted or prohibited. Investing in offshore companies may have an impact on the taxation of the investment.
Offshore hedge funds are private investment partnerships that only accept professional, institutional, accredited or qualified investors. They require a minimum investment volume and a minimum investment period.
Direct investment in locally regulated hedge fund
If registered with and approved by the local regulator, a distributor may offer a hedge fund to the public. However, it is common for additional restrictions to remain e.g. no offer to retail investors.
Investment in exchange traded hedge fund
Some hedge fund strategies are available in closed-ended vehicles listed on a securities exchange. Depending on the process employed, a listing can result in a higher correlation to traditional assets. The closed-end structure also means that liquidity risk remains, and the fund will regularly trade at a premium or discount to the net asset value.
Investment in fund of hedge funds
The manager of a fund of hedge fund builds and manages a portfolio of Hedge Funds.
The Fund of Hedge Fund structure lowers the minimum amount required for investment, increases diversification, reducing the risks involved in investment and manager selection but adds a layer of fees and complexity.
Key features of Hedge Funds
When contemplating an investment in hedge funds, investors should consider the following key features.
Investment Horizon
Long-Term
Return Expectation
Predominantly capital gain.
Market Expectation
Independent of market expectations, e.g. rising, falling or trading sideways. Some strategies benefit from a high volatility environment.
Maximum Gain
The maximum gain is unlimited, comprised predominantly of capital gains.
Maximum Loss
Total loss of the capital invested.
Profit / Loss
Timing and quantum of returns are dependent on hedge fund manager and strategy employed, though typically independent of movements in liquid equity and bond markets.
Absolute return objectives typically drive returns with no benchmarking.
Trading Process
An investor in a fund or fund of funds will typically invest via a private bank or financial advisor, who will prepare the application forms and liaise with the fund manager on their behalf.
Trading Costs
Investing in and selling private equity funds create explicit and implicit costs for the investor. Private banks and financial advisers charge transaction fees for arranging the application and providing regular updates.
The fund manager will typically charge a management fee of 1.00 - 2.00% pa, with performance fees of 15% - 20% charged.
Advantages & Disadvantages
Advantages
- Returns are not typically closely correlated with traditional asset classes, providing a diversification benefit to portfolios
- May allow for participation in markets that are difficult to access via traditional financial instruments.
- Participation in markets and instruments not available to conventional financial instruments.
- Participation in market environments where traditional instruments offer few opportunities.
- Professional management with performance incentives.
- Reduced portfolio volatility.
- Opportunities for high returns at the expense of using high-risk investment instruments.
Disadvantages
- The investments are less liquid than traditional instruments.
- Shares are redeemed at specific intervals/times only and may be subject to a notice period.
- Hedge funds are not required to disclose their portfolio holdings and strategies in the same way as mutual funds.
- Minimum investment period (lock-up period)
- Usually not listed/illiquid participation
- Price uncertainty: limited regulations concerning the calculation and publication of NAV.
- Only accessible for professional/institutional/ qualified investors.
- Largely unregulated
- Lack of control: the fund manager has absolute trading authority.
- As they are less regulated, hedge funds may not need to disclose their portfolio composition and risks. The investor, therefore, has less information to help him judge the risks.
Risks
Liquidity Risk
The risk that an investor cannot sell an investment at a fair price within an expected timeframe is called Liquidity Risk.
Liquidity risk is even more prevalent in alternative investments such as hedge funds, where redemption may only be possible with advance notice and at specified dates, and the underlying assets may themselves be illiquid.
Minimum holding periods may apply. A hedge fund is not necessarily listed and tradable on the secondary market.
Manager Risk
Manager Risk is the risk that an investment manager or investment management team fail to meet their investment objectives or drifts from their stated investment mandate or style.
Operational Risk
As a result of reduced regulation and low levels of transparency, the operational risks and fraud risks are higher than with traditional funds.
Market Risk
The investor is exposed to the general economic environment, e.g. interest rate changes, exchange rates (when not denominated in home currency). The psychology of the market participants tends to enforce trends, and in a market of expectations, not all expectations may be rational.
Hedge funds aim at absolute returns independently of the market environment, investing in various instruments and making use of derivatives and advanced techniques such as short sales and leverage.
Therefore, the investment strategy drives the risk-return profile of the fund.
Currency Risk
The hedge fund or underlying investments may be denominated in other currencies than that of the investor's natural currency, exposing them to currency risk.
Legal and Regulatory Risks
Local legislation may restrict participation in offshore investment vehicles and influence the taxation of hedge fund investments.
Important Information
Walbrook Wealth Management is a trading name of Barbacane Advisors Pty Ltd (ABN 32 626 694 139; AFSL No. 512465). Barbacane Advisors Pty Ltd is authorised to provide financial services and advice. This post is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or needs, unless expressly indicated otherwise. You should consider whether the information is suitable for your circumstances and where uncertain, seek further professional advice. The author has based this communication on information from sources believed to be reliable at the time of its preparation. Despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice, and we are not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, we accept no liability for any loss or damage as a result of any reliance on this information.
