Hedge funds have always been perceived as a dubious financial practice, promising shiny returns only to ultimately deceive the investor.
A sector full of unscrupulous people trading huge sums of money through unconventional means is how it is usually thought of, and both politicians and the general public place much of the blame for the recent financial crisis on the hedge fund industry. Besides, there is no doubt that the Bernard Madoff scandal cut away the last shreds of respectability and trust hedge funds held in the public eye.
In the first half of this decade, those who promoted hedge funds complained that there was no movement in the markets from which they could make money. They were adamant that when the markets moved, they would make money for their investors. We were repeatedly told that, because of the variety of assets which could be held and the trading practices that could be employed, hedge funds had the flexibility to make money even when markets fell.
They argued further that what they really desired was volatility – a volatile market would allow them to produce spectacular returns for their clients. This is when they would really earn the elevated management fees they were charging.
So the question investors are asking is why have the majority of hedge funds imploded since September 2007? One hedge fund manager estimates the current size of the hedge fund industry to be around $1.2 trillion (Dh4.4trn), down from $2.5trn at peak.
Why in the most volatile markets in living memory have the hedge funds not produced the spectacular returns they promised, or not even hedged out the risk and broken even? And why have they made monumental losses and, in many cases, suspended trading?
Combine this sentiment with the financial sector's desire to stop short-selling and increase hedge fund transparency and it would be a logical conclusion that this is not the time to be buying hedge funds. Some would even argue that the end of hedge funds, in their current form at least, is nigh.
Indeed, the EU has already published a draft policy on 'Alternative Investment Fund Managers' with the view to compel hedge fund managers, and their funds, to register with national regulators and produce regular reports and trading disclosures. The proposal also recommends arbitrary leverage caps – limits on the amount of money that hedge funds can borrow.
However, the many critics of the policy believe that, rather than preventing a repeat of the financial crisis, it would simply result in the hedge fund managers moving to less restrictive, and less regulated, jurisdictions. Others suggest that the changes would simply result in higher compliance costs and these would be passed on to end investors – giving customers a raw deal and making the asset class even less attractive. The Associate of British Insurers went so far as to call the EU's plans "not fit for the purpose".
Another factor that needs to be resolved, albeit internally, is that of liquidity. In the past, many funds had a mismatch between their strategy time frames and the liquidity terms they offered investors.
Now that the myth of ever-present market liquidity has exploded, it has been suggested that hedge funds adopt a quasi-private equity style model, with the money locked in until returns are realised. This kind of approach would be particularly relevant for credit and distressed debt strategies. However, convincing nervous investors to keep their money in for longer will be difficult and this removes one of the key selling points of hedge funds.
But are there hidden opportunities in the hedge fund wreckage and would an investor be wise to speculate against the trend as so often proves most profitable?
It is probably wise to stay clear of some of the existing funds with impaired liquidity and the risk of collapsing under the weight of their own borrowing. But for new hedge funds, and those which were more prudent in the past, there is a greater potential for profit now than at any time in the past.
It has to be remembered that, by definition, a hedge fund remains an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
If hedge funds can raise the money, there are some great buying opportunities for them at present and, possibly, the first real chance for hedge fund managers to take full advantage of their remit.
Additionally, hedge funds continue to add diversity to a balanced portfolio, along with access to trading strategies not normally accessible to the average investor – arbitrage being the prime example.
Whilst it is important to remember that hedge funds are not the panacea that they were built up to be, do not write them off as a valuable part of a diverse investment portfolio. If care is taken when selecting a fund, it could punch well above its weight.
Take some time and enquire how much debt the fund took on in the "boom years". Also look at how much money is being taken into the fund now; while there are great opportunities at present, a hedge fund cannot take advantage of these if it is not receiving new money to invest. Lastly, research the fund managers: Have they come from a long-only investment background and, if so, were they able to adjust to the long/short world of hedge funds?
If your findings are positive, it is likely the fund will not only survive these turbulent times but actually flourish in the months and years to come. And who knows, these phoenixes, which rise from the ashes may even give hedge funds a better name.
- Darren Ashley is founder and Managing Director of Candour Consultancy. www.candourconsultancy.com
Investing in Hedge Funds
It is possible to invest in hedge funds directly. However, unless you are an experienced investor who has the time to conduct extensive due diligence on the funds of interest, this may not be a wise option. Additionally, most hedge funds have a minimum investment of $50,000, which means the average investor may not be in a position to invest in more than one fund – not great if you are looking for a diversified investment portfolio.
The best way to purchase hedge funds is via an investment vehicle such as an offshore bond or investment trust. Most investment vehicles will be able to purchase funds at institutional rates, which means you will get more units for your investment. Often, the minimum investment level is reduced from $50,000 to $10,000 for institutional investors.
Keep up with the latest business news from the region with the Emirates Business 24|7 daily newsletter. To subscribe to the newsletter, please click here.