It is important to understand that a “hedge fund” is a name given to a structure, not a strategy, much as a ‘Unit trust’ or ‘Mutual Fund’ is the name of a structure. There are approximately 14 key investment strategies used by hedge fund managers, each offering different degrees of risk and return. Any two hedge funds can be as distinct as any two mutual funds.
As mentioned above, the 14 main hedge fund strategies bear little correlation to one another, and even less to conventional equity investments. They do, however, share certain common characteristics.
Hedge funds are often domiciled in offshore locations, offering the fund managers considerable flexibility in the choice of investments, markets and strategies.
Hedge funds strive to deliver positive, absolute returns under all market conditions, rather than performance relative to a benchmark.
The returns on most hedge funds have historically had a low correlation to traditional investment returns.
Whereas traditional investment products are linked to a market, benchmark or index, and can only profit from rising asset prices, hedge funds can use techniques such as short-selling to boost performance and reduce volatility.
Capital preservation is an important focus for most hedge fund managers.
A hedge fund manager's remuneration is predominantly down to investment performance, meaning the sector attracts talented managers, and does not suffer poor ones for long.
In addition to performance-based pay, hedge fund managers often invest meaningful amounts of their own capital alongside their investors, making their interests truly aligned with those of their investors.
Funds that grow too large can be unmanageable, which is why the majority of hedge fund managers place constraints on the size of their funds, believing that there is an optimum level of assets which they can manage efficiently.
The table below mentions some of the aforementioned characteristics of hedge funds, and clearly illustrates the tangible benefits of having hedge funds in your portfolio vs. holding only traditional equity investments.
Hedge Fund Funds
Returns in positive markets
Often catch a good proportion of upside
Similar to the underlying market
Returns in negative markets
Significant reduction in downside
Similar to underlying market
Volatility similar to underlying market
Correlation to market direction
Low to medium depending on strategy type
Investment instruments and techniques
Large proportion is performance-related
Generally fixed annual fees, but can also be performance-related
Investment by manager in own fund
Generally involving meaningful sums
If you would like to view an overview of the main hedge fund strategies clickhere.