What is a Hedge Fund? What's a Fund of Hedge Funds?

The Weekender / Business Day 26/27 Aug 2006

Hedge Fund Definition: an investment structure for managing a private, unregistered pool of investment funds aiming to achieve a positive return regardless of how the markets perform.

That's sounds rather indistinct, so let's back up a little to get a clearer picture...

Investment markets around the world, including SA, are experiencing high levels of volatility. Various factors have been blamed, including an expected slow down in the global economy, high oil prices and terrorism.

One method of reducing volatility and securing the returns on investments is through the process of asset allocation and diversification. This is the allocation of the investment funds amongst different types of assets or investments in order to get the best return for the least level of risk.

Alternatively, your financial planner may determine what your level of risk is and structure your portfolio to achieve the maximum return for your level of risk.

This is where a hedge fund may become relevant. Such funds are seen as a separate asset class to shares, bonds, property and cash. The reason for this is that their performance has a low correlation to that of the other asset classes.

Hedge funds offer protection when the market moves down. They may therefore be used in your investment portfolio to increase diversification and improve.

However, it is important that you understand the associated risks of such investments and how they operate.

It is difficult to give an clear and exact definition of a hedge fund or how they operate. The reason is that there are various related investment strategies. Vimal Chagan, Chief Investment Officer of independent financial planning company Acsis says that “these funds aim to deliver a positive return over all time periods and could also be categorised as absolute return funds”.

It is important that you know what strategy the fund you invest in uses, as this is primarily what determines its riskiness.

Higher risk funds use gearing or leveraging to amplify gains and potential losses. Leveraging allows the fund manager to extend the exposure of the fund beyond that what is actually invested in the fund.

Other funds are more risk averse and do not use leveraging. Unit trusts are not allowed to use leveraging.

Unlike unit trusts, hedge funds are not regulated in South Africa, therefore you will not have the same levels of protection as when investing in a unit trust. Your financial planner should therefore conduct a thorough analysis to investing your money in such a vehicle.

These types of funds are also not as liquid as unit trusts. You are allowed to redeem your unit trust investment at any time on short notice, but money in a hedge fund may sometimes be redeemed only on a monthly basis.

Another important aspect to consider is costs. Hedge funds often have higher costs and performance fees. The more you pay in costs and fees the better your investment has to perform before your investment produces a return.

However, these aspects have not detracted from the popularity of these types of fund investments. It is determined that in South Africa there is more than R16 billion invested in them. Experts suggest that this figure is likely to grow even further due to current volatility.

Such Investing is Not for Everyone

There are usually very high minimum investment amounts should you invest directly.

They are also complex structures which are not as simple to understand as other products such as unit trusts.

It is best to consult with your financial planner to determine whether hedge funds have a place in your portfolio.

Once your financial planner has followed the six-step financial planning process as recommended by the Financial Planning Institute (FPI), he may then determine that you do require such an investment.

If so, the safest bet may be to use a fund of hedge funds.

In this instance, the fund of funds manager will do the research and select which are the best funds for your purpose. Investing in a range of these funds will create further diversification and will protect you against great losses.

As I have said previously in my column, choose a financial planner who is focused on your best interests, not merely aiming at selling a new product.

Visit the website of the FPI on www.fpi.co.za to select a qualified certified financial planner.

Debbie Netto-Jonker, CFP™, is founder of Netto Financial Services and was financial planner of the year in 2001.