Diversification is key

Many think it's insane to invest in hedge funds, but if investing is all about managing risk, hedge funds could be an attractive investment vehicle

  • E-Mail
By  Massoud Derhally Published  March 10, 2002

|~||~||~|Mention hedge funds to someone and the response is that they are risky investment instruments or a good alternative to traditional investments. Hedge funds have received considerable attention during the last decade, most particularly because of their role in a number of recent exchange rate crises. Yet at the 3rd World Hedge Fund Conference held in Dubai in February Arabian Business talked to industry insiders who painted a picture different from what most people identify with hedge funds.

The industry today is estimated to be worth around US$400-$600 billion and growing at about 20% per year, estimated to reach US$1.5 trillion by 2005 with between 5,000 and 6,000 active hedge funds. Hedge funds refer to funds that can use one or more alternative investment strategies, including hedging against market downturns, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and arbitrage. The Middle East market is practically non-existent when it comes to hedge funds.

Angus Blair, managing director of London based Safron Advisors, says that while some hedge funds look at emerging markets such as Eastern Europe, Greece and Turkey they do not invest in the Arab world. "The reason why hedge funds do not invest in the Arab world is because liquidity in stock markets is very low. Consequently it is difficult to enter in volume and more difficult to exit in volume without affecting the price adversely," says Blair.

One of the conference's tasks was reducing fears brought about by stories like that of the Long Term Capital Management (LTCM) fund. LTCM was a fund that had grown to US$7.3 billion was on the verge of collapse in September 1998, after mistakenly gambling on a convergence in interest rates. The collapse of the fund sent ripples in the investment banking community and the world of hedge funds. The activities of hedge funds have led to a major debate over their impact on the world financial system and to calls from some quarters that hedge funds be regulated.

But do stories like that of LTCM paint a doom and gloom picture of the hedge fund market? Are the risks associated with hedging funds the same of those of a Russian roulette table or can they actually be used to enhance investment?

The conference in Dubai highlighted that hedge funds provide a viable alternative to investors seeking capital appreciation as well as capital preservation in bear markets and that the vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal. LTCM was only one kind of a fund and not all hedge funds are risky, according to Antoine Massad, associate director of Man Investment Products, which sponsored the conference.
"It is a misconception when markets and people think that hedge funds are risky. Most hedge funds that are diversified, excluding private equity and venture capital, are much less risky than investing in stock markets," says Massad. "If we take world stocks over the last few years the volatility is 17-18%. If you take the most aggressive hedge fund that we offer it has a similar volatility. The most conservative hedge fund we offer has a volatility that is lower than US Treasury bonds," adds Massad.

A good example that Massad points to is that you have many hedge funds that are single strategy, with a single fund manager, and that is risky because it would be like investing in one stock. LTCM is a good example: it had a single strategy, single manager and was highly leveraged. "All of our funds are multi-managed and have a multi-strategy," says Massad.

Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets - unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk. Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, who have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds. Massad agrees and says, "The most conservative investors, like pension funds, are realising that hedge funds should be part of a portfolio because of the non-correlation to the traditional investments. By being non-correlated you are diversifying and lowering the risks of the overall portfolio.""

Increasingly, institutional investors are entering into hedge funds and General Motors pension fund in August 2001 allocated US$200 million to Glenwood, one of Man Investment's subsidiaries, which was the first time General Motors ever invested in a hedge fund. Investors at the retail level increasingly want to access or enter hedge funds.

So what options do you have should you want to invest in a hedge fund? At Man Investments, Massad says there are two types of public offerings. Open-ended funds allow investors to enter and exit on a regular basis with a minimum investment of US$30,000. The other offering is known as a structured fund with a fixed offering and the minimum investment is US$50,000. Unlike what some may say are customary high fees levied on investors, Massad explains that charges depend on the investment manager. "Usually we charge a management fee and an incentive fee. The bulk of money is made for us in incentive fees but to charge those fees we have to perform. The average incentive fee is 20% of the net profits, which means each time we have to reach a new high."

Given that GCC nationals have invested US$1.4 trillion overseas, according to Angus Blair, investing in hedge funds seems only to perpetuate the relatively poor liquidity levels in GCC markets. However, Massad says that Man Investments and other hedge fund companies are not competing with what is offered and available locally and are not trying to take money away.

"When someone asks 'why should we invest with you?' I would say diversification. The local or regional investment opportunities are limited. We are here to add value in the context of diversification. What has happened with the local banks of the region is that investors are investing outside of the region anyway, so the banks came to the conclusion: 'why not provide the opportunity for the investors to invest through the bank,'" says Massad.-by Massoud Derhally

Add a Comment

Your display name This field is mandatory

Your e-mail address This field is mandatory (Your e-mail address won't be published)

Security code