The hedge fund industry is currently worth around $208 billion in Australia alone*. But while investors are familiar with the concept of traditional managed funds, there is less awareness of how hedge funds operate, which is the root of many misconceptions. Here we debunk some of the common myths surrounding hedge funds.

What are hedge funds?
The RBA says the term ‘hedge fund’ is typically applied to “managed funds that use a wider range of financial instruments and investment strategies than traditional managed funds, including the use of short selling and derivatives to create leverage, with the aim of generating positive returns regardless of overall market performance”**.

In other words, hedge funds aim to ‘hedge’ or manage the risks of a volatile market by using a variety of investment strategies.

Myth no.1 – hedge funds are only for the very wealthy
This may have been true in the past, when hedge funds were commonly set up as private investment partnerships open to a limited number of investors and requiring a substantial initial investment, but these days, investors can access hedge funds with as little as $20,000.

One of the drivers behind the increasing popularity of hedge funds is that some investors are disillusioned with the returns they’ve achieved from more traditional Australian equity managers over the last five years, and are looking for strategies that can give them a positive return in any market environment. An absolute return hedge fund aims to do just that.

Myth no. 2 – hedge funds are risky
Most hedge funds are active managers of investment risk with defensive strategies in place.

An index fund, perceived by some as a ‘safe’ option, is at the mercy of the volatility of the market it tracks; susceptible to fluctuations which aren’t actively managed. However, a market neutral hedge fund targets a positive rate of return regardless of the return of the market, which means the risk is actively monitored, positions are hedged and exposure to the market limited as required.

Some hedge funds are purely focused on preserving capital (ie. your original investment), so making strong returns over the short term is not their primary focus. Other hedge funds only trade when opportunities arise and have clear investment guidelines which act as a framework for their investment decisions – such as exposure limits, risk management frameworks, stop loss levels, etc.

Before you select a hedge fund, it’s critical to undertake your due diligence – people and processes are critical, as is a robust framework for managing risk.

Myth no. 3 – hedge funds have exorbitant fees
The typical hedge fund fee structure in Australia is 1.5% management fee and 20% performance fee. At first glance, this appears to be high when compared to long-only domestic managers. To see true value for money, however, you need to focus on returns not just fees. If you’re paying very low fees but the fund is not performing, this is a false economy.

Performance fees are only payable when the fund outperforms the benchmark, meaning investors pay for the manager’s skills and expertise when they’re getting a good return on their investment.

Myth no. 4 – hedge funds are illiquid
In Australia, redemption restrictions and high withdrawal fees are rare. There are a number of retail hedge fund managers in Australia who price their fund daily and most have a straightforward redemption process with relatively low withdrawal minimums ($10,000).

Myth no. 5 – hedge funds are unregulated and lack transparency
In Australia, hedge funds are as tightly regulated by ASIC as any other managed fund, if not more so. ASIC has recently introduced changes to reporting and increased investment process transparency, which will further improve the current status quo.

Whilst a strong track record is an important element when assessing hedge fund managers, transparency and openness around investment processes, internal governance and compliance controls is also critical.

Conclusion
Hedge funds play a unique role when teamed with a portfolio of more traditional investment products. They can reduce volatility and increase returns, as returns are correlated quite differently than those of a traditional long-only fund. Next time you’re creating a personalised portfolio, consider adding a hedge fund to the mix.

* http://www.basispoint.com.au/hedge-fund-directory/ 
**http://www.rba.gov.au/publications/fsr/2004/sep/pdf/0904-2.pdf
 

Source: Bennelong, August 2013