Hedge funds have come a long way over the last decade from 'cowboy investments' for the rich, to serious alternatives to the traditional asset classes accessible to all investors. In the late 1980s and early 1990s, when hedge funds were identified with the likes of George Soros' Quantum Fund and Julian Robertson's Tiger Fund, high returns were their mantra. What made hedge funds even more appealing was their exclusivity. Only those with either the right contacts or sufficiently large amounts of money could buy a ticket on the hedge-fund train. Then there was the Long-Term Capital Management (LCTM) calamity, Soros began to focus on philanthropy and Robertson went the way of the Balinese tiger.

Absolute rather than 'super' returns

These days, hedge fund products are widely distributed and focus, not on the promise of super returns, but on risk reduction and 'absolute returns', that is, positive returns in all markets, good and bad. Returns of six or eight per cent may not appear sufficient at times when the index generates 18 per cent. However, those same returns are welcomed when the index produces negative five per cent. An investment with the ability to offer such a return profile throughout all market conditions has the potential to enhance long-term returns, and diversify the overall risk, of a portfolio of otherwise traditional assets. This is the hedge fund manager's aim.

In a bull market, most investors are satisfied when almost everyone is enjoying strong positive returns and the focus is on beating the index or the average return. In bear markets, most investors gain little satisfaction from being told their investments have outperformed the index average if those returns are in fact negative. It is these current conditions that see investors becoming more attuned to the idea of absolute returns.

A big hurdle faces prospective investors however, in trying to gain a clear understanding of the assets used in hedge funds and the methodology employed to deliver these absolute returns. In considering any hedge fund investment, investors should ask themselves:

Do I want it to enhance my overall returns?

Looking upon alternative asset classes as a variation on a theme is helpful because, rather than truly different types of assets, they are more accurately described as adaptations of the traditional asset classes. Put simply, standard investment in the four traditional asset classes, equities, fixed-interest, property and cash, involves taking a stake in assets in the hope they will appreciate over time. Generally, such investments in a particular class will wax and wane together depending on the state of the market for that asset class.

Absolute return hedge fund managers, on the other hand, seek to exploit specific market conditions for these traditional assets to generate positive returns no matter what state markets are in. The fact that their returns are not highly correlated with the inevitable swings in investment markets means they can potentially diversify a portfolio of traditional assets and smooth out returns. The extent to which they achieve this depends on the risk characteristics of the portfolio as well as the degree of correlation of returns of the alternative style relative to other assets in the portfolio.

For more details email  Info