Using the Versatility of Hedge Funds
June 30, 2013 | Topics: Alternatives
What is a Hedge Fund?
- Hedge funds are private pools of investment capital with flexibility to buy or sell a wide range of assets
- One common attribute is that they seek to profit from market inefficiencies, rather than relying purely on economic growth to drive returns
- There is no "one-size-fits-all" and the types of investment strategies pursued by individual hedge funds are extermely diverse
As a group, hedge funds are pools of investment capital that have the flexibility to employ a vast range of trading strategies in both traditional and non-traditional markets. Because of this versatility, hedge funds can bring diversification to a portfolio that is hard to find elsewhere. However, the flipside to having all of these options is that hedge funds rely more heavily on manager skill to generate returns than market performance. That is why the difference between the best and worst performing hedge funds is much larger than traditional investments, making choosing the right investment manager even more critical.
How Can Hedge Funds Enhance Diversification?
Creating a truly efficient portfolio relies on bringing together investments that respond to market events differently. Diversification potential offered by hedge funds comes from:
- Broad Opportunity Set and fewer restrictions on investments allow more opportunities to discover investments that are less correlated
- Less Dependence On Market Direction, which can help to minimize volatility
- Trading Strategies That Seek Out Market Inefficiencies, where highly skilled managers can add significant value over time
Not All Hedge Funds Are Created Equal
Unlike performance of more traditional stock and bond investments, there has been a larger spread between the highest and lowest returning hedge funds. For instance, note below where the difference was 38.9% for hedge funds, compared to 11.0% for large cap core funds and 4.6% for U.S. government bond funds. This large variation in hedge fund returns makes the selection of specific managers and funds even more critical.
What to Consider When Choosing
Choosing a manager based on their past track record is a given, but there are other factors that are arguably just as important to consider:
- Investment Objective: What are you trying to achieve with this investment (e.g. lower volatility, enhanced return, less correlation to other investments)?
- Structure: Are you looking to select a single manager / strategy fund to build out your own allocation to hedge funds or are you looking to select a fund of funds to manage an allocation for you?
- Team: What is the makeup of the investment team in terms of diversity, experience and history, and the culture of the overall organization?
- Risk Management: Is risk management an independent function that provides checks and balances to the investment process?
- Operations: Does the fund have a sound operational infrastructure backed by dedicated support groups (e.g. legal, technology, due diligence) to allow the investment team to focus solely on investing?
Hedge Fund Strategies: Defined by Area of Focus
In our view, hedge fund strategies can be categorized by area of focus and whether they seek to generate fairly stable returns regardless of the market environment or seek to capitalize on movements in underlying markets. Some of the most recognized hedge fund strategies are:
- Long/Short: Involves buying and/or selling equity or credit securities believed to be significantly under- or over-priced by the market
- Managed Futures: Invests in various global futures markets and takes both long and short positions in items such as agricultural products or precious metals
- Global Macro: Takes views on the direction of markets and seeks to profit from changes to broad securities markets, interest rates, exchange rates and prices of commodities
- Distressed: Purchases securities of companies that are going through restructuring and looks to profit from the securities once restructuring is complete
- Multi-Strategy: Flexibility to invest in multiple hedge fund strategies at a given time
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The information on this Web site is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy, or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.
Incorporating alternative investments into a portfolio presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.
Investing in alternative strategies such as a long/short strategy, presents the opportunity for losses which exceed the principal amount invested. There is also the possibility that long and short strategies could both fail, thereby increasing volatility and potential losses.
Compared to a traditional long only portfolio, the potential for volatility (compared to the market and the fund's benchmark) can be greater given the fund's additional long exposure along with its short exposure.
Hedge funds may not be suitable for all investors and often engage in speculative investment practices which increase investment risk; are highly illiquid; are not required to provide periodic prices or valuation; may not be subject to the same regulatory requirements as mutual funds; and often employ complex tax structures.
Utilizing private equity involves significant risks along with the opportunity for substantial losses.
Investors should consider the investment objectives, risks, charges and expenses of any fund carefully before investing. The funds' prospectuses and, if available, the summary prospectuses contain this and other information about the funds, and are available, along with information on other BlackRock funds by calling 800-882-0052. The prospectus and, if available, the summary prospectuses should be read carefully before investing.
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