How To Invest In Hedge Funds – Part One
In 1949, Alfred Winslow Jones launched a new kind of investment fund in America.
Raising $100,000, including $40,000 of his own money, it aimed to reduce, even eliminate, losses by simultaneously going ‘short’ (selling shares borrowed for the purpose) of stocks that had been bought (‘long’ positions).
So, like a bookmaker, the fund hedged its bets, sacrificing some profit to guard against loss.
Additionally, the fund borrowed (‘leverage’), using its portfolio as collateral, in order to buy more stocks with the loans.
Jones also bought on margin, whereby his fund invested with borrowed money.
But he made a partial payment (‘margin’) to cover the lender’s risk of a fall in the price of the security bought with the loan.
As well as an annual management fee, Jones could earn a performance incentive. He took a percentage of the profits made by the fund.
The first hedge fund
Legally, the fund was a limited partnership (LP or LLP), thereby capping investors’ liability at the amount of their subscription.
The entity that managed the fund was a general partner, wholly and separately responsible for its own financial commitments.
In short, the Jones fund included, for the first time together, the main elements of what we now call a hedge fund:
- A partnership-type structure Charges a performance fee Can go long or short
- Has an unrestricted investment policy
- The manager shares the risk with investors through personal co-investment.
Now, 70 years since Jones started out, there are some 10,000 hedge funds in the world, possibly as many as 15,000, with over $3 trillion in assets. America is the largest centre, with about 8,500 funds and well over $2 trillion in assets.
A long way behind, London is the second-largest, with over $400 billion managed in, perhaps, 1,000 funds.
Note that these numbers are themselves hedged with qualifiers such as “possibly” or “perhaps”.
When it comes to quantifying hedge funds, there are a few problems.
What IS a hedge fund?
First, observers differ on what actually constitutes a hedge fund.
Some do, some don’t count funds that invest in other funds (‘funds of funds’).
Others eschew CTAs (‘commodity trading advisers’, who trade derivatives based on financial securities and/ or commodities).
Even some ‘long-only’ funds (which don’t go short) might be included because they happen to levy a performance fee.
All of this doubt arises from the fact that hedge funds are, mostly, unregulated and private. Many of them only report to their investors, not to the media.
The lack of information is also because most funds have to be established in tax-neutral jurisdictions, such as the Cayman Islands.
This is in order to make them accessible to an international clientele.
One cannot Google performance or other data from such locations, nor are those numbers, with a few exceptions, to be found in the Financial Times.
Nonetheless, the phenomenal growth of hedge funds has been abundantly clear. The most important reason has been a transformation in the types of investor using them.
For a long time, being unregulated, hedge funds could only be offered to financially knowledgeable subscribers.
There was no recognised or even workable test for that attribute.
So investors were, typically, required to have at least $1 million in financial assets, excluding their homes, cars, and other material goods.
Therefore, the dominant kind of investor was a rich individual or family.
Hedge fund pioneers
That began to change in the 1990s, after a pioneering 1987 hedge-fund allocation from Yale University endowment.
This improved its portfolio returns so effectively that other American university endowments also invested. In turn, that encouraged US pension schemes to get involved, followed by their counterparts elsewhere in the world.
Today, over 5,000 institutional and other professional investors, from the largest public- sector retirement schemes to small wealth managers, allocate a significant minority of their assets to hedge funds.
These investments represent some two-thirds of the funds’ assets, worldwide.
Such investors are not just seeking higher returns. Indeed, given the disappointing level of hedge funds’ performance in recent years, that aim has been thwarted to a considerable degree.
Rather, those professionals want two other benefits at least as much as performance.
The first is the ‘insurance’ that was demonstrated by the success with which hedge funds weathered the 2007-08 financial crisis.
Then they lost ‘only’ around 20% as world markets dived by 40%. A significant number of funds even showed positive returns because they had been short.
The second benefit is known as non-correlation. Compared with mainstream investment vehicles, hedge funds tend to exhibit contrary patterns of return. They are more likely to prosper when less flexible funds are struggling, and vice versa.
In a portfolio that holds a variety of funds, that lack of correlation helps to smooth out the peaks and troughs in performance.
This reduces the overall risk.
The effects of regulation on hedge funds
Meanwhile, the advent of regulation has brought about yet another change. Almost eight years before the Great Financial Crisis, the bursting of the ‘dotcom’ bubble in 2000 was followed by a long period of unpredictable markets.
That created demand from retail investors for funds that could profit from such volatility. Meanwhile the prospect of access to retail interest fostered greater readiness among hedge funds to be regulated.
Also, retail investors are only allowed to use regulated investment products.
But pension schemes and other professional investors, who are free to invest pretty much anywhere and in anything, also like the reassurance of regulation.
It helps them to justify their investment decisions to clients.
In the EU, regulations for UCITS (Undertakings for Collective Investment in Transferable Securities) allowed the inclusion of many hedge funds.
In the UK, where unit trusts aren’t allowed to charge performance fees, this spurred retail interest in these ‘alternative’ or ‘alt’ UCITS.
That category now includes about 1,500 funds and over £500 billion in assets, having grown by some 30% a year from nothing, just over a decade ago.
The second, and final, post on this topic will discuss the pros and cons of investing in hedge funds for investors who are neither rich nor professional.
There may well be some surprises.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
