Reducing risk with hedge funds

Hedge funds, while not a new invention (they're been around since 1949) are starting to shake of the moniker of fad and become more accepted by advisers in New Zealand.

For more than a year they have been getting a large amount of attention, and fund managers have conducted plenty of presentations around the country explaining how these seemingly complex funds work and how they can be used in a diversified portfolio.

One of the questions which has been asked is: Are they just a fad like tech funds?

The answer seems to be no. Partly because they have been around for a while and there is historical data and research to back up their rasion d'etre. Secondly they are not fuelled by a bubble like tech stocks were. Thirdly, the returns being produced by hedge funds are nothing like the stratospheric numbers posted by tech funds at their zenith.

The two managers who had the market to themselves, Tower Managed Funds with its GAM-Multi-Trading Fund and OM Strategic with its OM-IP series and Hedge Plus have been joined by a number of new players.

Macquarie has its Titan Trust, and FGI Asset Management and Holroyd Capital run smaller funds. In the wholesale area Frank Russell has a fund and AXA has an Australian domiciled unit trust.

Rothschild are understood to be looking at making its Australian based Absolute Return fund available on this side of the Tasman, and Colonial First State is looking at putting a wholesale fund into the market.

Tower has just launched its Advantage Hedge Fund which invests in Deutsche Bank's highly regarded Strategic Value Fund.

Besides all these funds there are a number of shares funds, such as Platinum Capital and RIT Capital Partners which aggressively use hedging strategies.

As could be expected with an increase in funds there has been a significant pick-up in funds flow to this asset class.

Tower has $153 million in its Multi-Trading fund and reports flows to its Advantage fund are good. OM Strategic refuses to say how much money it has raised, but the number is believed to large. Meanwhile Macquarie says it raised more than $70 million in its recent offering for the Titan fund.

Hedge funds are often thought about solely in terms of the returns they offer investors, but the real story is how they help reduce risk in a portfolio.

If well-selected and used properly hedge funds have the ability to not only increase returns, but also smooth out volatility.

"A diversified portfolio of hedge funds can actually lower risk in a traditional portfolio," Colonial First State Joe Fernandes says.

Research presented by various fund managers recently has shown how hedge funds, when used in a portfolio, play a positive role in enhancing risk adjusted return.

While managers are only advocating people put a small proportion of their money into hedge funds, the research shows that the optimum allocation is a staggering 62% allocation to hedge funds.

One of the distinguishing differences between hedge funds and a traditional equity fund is that you are swapping market risk for manager risk.

Deutsche Asset Management director David Zobel says there is still a lot of myth around hedge funds.

"Hedge funds rely on manager still more than markets."

The best way to manager the manager risk is the standard tool - diversification.

The common wisdom in the hedge fund world is that you invest in a pool, or fund of fund, hedge fund.

"You need a portfolio of a variety of hedge funds to achieve optimal results," Fernandes says.

This, he says, will improve returns and lower risk.

"Investing in one hedge fund will probably achieve the reverse effect."

Fernandes reckons an investor needs to have exposure to between 15 and 25 hedge funds in order to get good, long-term returns at acceptable risk levels.

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