The term ‘hedge funds’ covers a broad array of funds that invest in a wide variety of asset classes with highly variable risk factors and returns. Their common goal is to achieve a positive return, regardless of how the market behaves. By aiming for ‘absolute’ returns, with hedge funds reference is made to performance in ‘absolute value’, as opposed to performance weighed against an index.

Hedge funds managers are not tied to the limitations of a benchmark. They invest in markets that show the most inefficiencies and where their expertise can generate possibilities to achieve greater profits. Talented hedge fund managers can be active on all markets, in all asset classes and make use of various management techniques (short-selling, leverage effect, etc.) and financial instruments (options, futures, swaps, etc.).

There are a great variety of hedge funds. In addition to the defensive hedge funds, which aim to neutralise the market impact, more aggressive strategies are available that resolutely seek a specific exposure to the market. Many of the strategies pursued by hedge funds benefit from being non-correlated to the direction of equity markets.

Overall, two major categories can be distinguished. On the one hand the unfocused strategies aim to neutralise the risk inherent to the underlying market in which they invest and focus only on taking advantage of currency fluctuations. Convertible arbitrage, fixed income arbitrage, merger arbitrage and market neutral strategies belong to this category, inter alia.

On the other hand the managers of funds with a focused strategy invest more dynamically, since they also aim to make use of their vision of the behaviour of a specific market, both upwards or downwards. Within this category, a number of approaches are possible, e.g., long/short equities, global macro, managed futures and distressed securities.

Unfocused strategies typically hold a lower risk than focused strategies. A simplified example illustrates the difference between both.

Suppose a manager with an unfocused strategy concludes that they do not have a clear overview of the development of the financial sector in absolute terms. As a result of their thorough knowledge of the sector, they believe, however, that share A will perform better than share B. They will therefore buy share A at 100 and sell share B unsecured at 100. Their aim is to achieve a balance between the purchase and sale figures. If the market is bullish for financial shares in which share A rises to 110 and share B to 108, the manager’s profit will be 2% (performance difference between A and B: (100+10) – (100+8)). But even in a bear market, in which A would drop to 95 and B to 93, performance would be (100-5)-(100-7) or +2% over this period. They therefore made the right choice and will earn money regardless of the market condition.

The manager with a focused strategy, who claims to know about macroeconomic phenomena such as the development of interest rates, their impact on the progress of the share market and bonds, etc., could, for example, sell shares uncovered if they believe that a market is about to decline in its entirety. By selling uncovered they sell the assets and will buy them back later at a cheaper price, thus creating added value (short-selling).

The addition of hedge funds to portfolios contributes to greater stability and increases their return potential in the long term, yet hedge funds are not completely risk-free. Possible negative returns can obviously never be excluded. In addition to the risks specific to each investment, hedge funds also pose specific risks:

• Hedge funds are typically domiciled in countries where government control is more limited.
• Hedge funds frequently lack transparency, as the fund often publishes very little information about its strategy and financial structure.
• The broad range of products used, inter alia, derivatives, and the option to make use of loans in order to create a leverage effect, make the hedge fund risky if the manager makes the wrong decisions.
• Investments in hedge funds often lack liquidity.

Contrary to what is often thought, it is also possible to limit the risk by means of short-selling. If, for example, a manager wishes to take advantage of the difference in value between two shares by buying one and selling the other in the same market sector, its performance will not be influenced by the development of the underlying sector. Only the exchange difference between the two shares will affect performance. If rates plummet, the return on the hedge funds typically drops less drastically than the market return. Hedge funds can therefore provide protection in a bear market.

The specific risks linked to hedge funds can be avoided by working with well-established ‘funds of funds’. ‘Funds of funds’ invest in hedge-type funds instead of investing in an individual hedge fund. The diversification inherent to the ‘funds of funds’ makes it possible to limit the negative impact should a single fund disappoint. By investing in a number of additional styles and strategies as well as in a broader range of underlying instruments (shares, bonds, convertible bonds, commodities, liquidities, etc.), the risk is reduced.

There are numerous other advantages linked to a ‘fund of funds’. They benefit from a broad specialisation by selecting the best hedge fund managers. For fund of funds managers thoroughly analyse individual managers and create a portfolio that combines the various techniques that are available in the world of alternative management in order to achieve an investment with a very specific risk profile.

In addition, hedge funds frequently lack transparency, as the fund often publishes very little information about its strategy and financial structure. Through a fund of funds the investor will be able to benefit from the expertise of the manager who monitors the quality of the underlying hedge funds at all times and regularly supervises performance.

Furthermore, the ‘fund of funds’ structure provides access to closed funds that are not available to most individual investors, either due to a high minimum deposit, or because they are closed to new investors.

Fortis Private Banking has extensive experience in alternative investments and in hedge funds in particular. A specialist team carefully monitors the hedge fund sector and its participants and uses the most advanced management techniques and well-established solutions. Investment risks are therefore reduced to a minimum at Fortis.