If you’ve lost your shirt on the stock market and you’re looking for investment alternatives, hedge funds offer an opportunity to get positive returns in falling markets explains Mark Hutchinson.

Hedge funds, traditionally the preserve of institutional investors and high net worth individuals, are beginning to open their doors to retail investors in Ireland. On the 19th of December last the Central Bank published a notice (NU 25) officially giving the green light to the sale of retail fund of hedge funds products to Irish investors.

This was a significant event for the hedge fund industry in Ireland and worldwide because the Central Bank is, in effect, recognising that these products can be beneficial to the retail investors’ portfolio. From an investor’s perspective, the development is particularly welcome because it allows retail investors to benefit from, rather than read about, the opportunities for positive returns in falling markets.

But aren’t hedge funds aimed at the rich?

Traditionally, hedge funds only opened their doors to the rich. (Typically, in the mid-1990s a minimum investment of euro1m would be expected). As hedge fund investing has evolved, from a multi- million euro to a multi-billion euro industry, so too have the product ranges with intermediaries now offering products with a minimum investment of euro12,500.

What’s the difference between a fund of hedge funds and a regular hedge fund?

As the name suggests a fund of hedge funds offers investors exposure to a group of portfolio manager selected hedge funds employing a range of trading strategies. To avoid exposure to specific manager or investment strategy risk a typical fund of funds would invest in 8 to 10 different hedge fund strategies, and 30 to 50 fund managers. According to Central Bank regulations a fund of funds can invest up to a maximum 5% of net assets in any one fund. This limit may be raised to 10% provided the management company of the underlying fund is authorised in an OECD jurisdiction.

But aren’t hedge funds high risk, what about LTCM?

The spectacular demise of Long Term Capital Management, created the largest amount of publicity the hedge fund industry has received to date. In October, 1998 LTCM had trading losses of euro3.6 billion, threatening the world financial system, and the fund had to be bailed out by a consortium of banks brought together by the New York Federal Reserve. Many column inches have been devoted to LTCM, but from an investing point of view, the lessons to be drawn from the failure are:

* Like equities, hedge funds are not a risk free asset class, just as companies go bankrupt, hedge funds will also go bankrupt. Many funds failed before LTCM, and many have failed since (but none so spectacularly).

* Like equities, when one fund goes bankrupt it does not mean all funds will go bankrupt.

* Therefore, as with equities, hedge fund investors should hold diversified portfolios of hedge funds.

Are any of these funds established in Ireland?

In a note dated 9th April 2002, A&L Goodbody, the Dublin based business law firm, estimated that there are approximately twenty five hedge funds established in Ireland. The attractiveness of an Irish Stock Exchange listing, the progressive regulatory attitude of the Central Bank of Ireland and the existence of a major funds industry in the IFSC, combined with a favourable Irish tax environment mean that this number is likely to grow significantly over the short to medium term.

How about fees?

The major drawback to hedge fund investing is the fees involved. Expect to pay an up-front sales fee of 2-3%, an annual management fee of 1-2%, and the fund will usually take a percentage of profits (10-20%) above a minimum threshold as an incentive for the hedge fund managers.

This sounds like a lot, but based on an investment of euro25,000, you are talking about euro500-750 up front, and then another euro500 per annum fixed. Any additional incentive fee will be happily paid, as the bigger the incentive fee, the bigger are the funds’ returns!

How do I choose a hedge fund? Isn’t the manager important?

Hedge funds, in aiming for positive returns irrespective of the state of world markets, rely on the skill and expertise of the manager more than conventional funds. As important as the manager is the strategy that the manager proposes to employ. The strategy that is used combined with the manager gives the fund its unique characteristics.

Constructing a portfolio of hedge funds can be difficult and time consuming. Identify the different strategies which you wish to invest in, and then look for managers with a strong track record. Larger funds are usually a sign of success as they have attracted more investment.

Alternatively, it may be more practical to invest in a fund of funds. This eliminates the need for extensive research, but it is still important to check that the fund of funds portfolio manager has a strong track record. You are effectively paying the manager a fee for administering and monitoring your slice of the portfolio of funds. The other advantage of fund of funds investing is that it allows access to a broader spectrum of funds that may otherwise be unavailable due to high minimum investment requirements.

How do hedge funds earn high returns in falling markets?

Hedge funds use a variety of different trading styles to profit irrespective of market conditions and tend to classify themselves according to their particular speciality. A few of the more popular strategies are described below.

Equity Market Neutral

Equity Market Neutral is the most popular strategy. With this strategy funds take matched long and short positions of equal monetary value in equities within a sector / country. The portfolio is heavily diversified with lots of long / short positions in many different stocks. The advantage of this approach is that the portfolio is neither heavily exposed to market movements nor stock specific news.

If for example the portfolio consisted of two equal size positions – long Bank of Ireland, short AIB, and the market dropped 10%, the loss from the Bank of Ireland position would be offset by the profit on the AIB short. However, if sudden bad news came out about a trading loss at Bank of Ireland causing the stock to plummet, AIB would remain unaffected, leading to large losses for the portfolio. In this case the portfolio is hedged against market risk, but not against stock specific news. However, if the AIB/Bank of Ireland trade was one of 200 positions, overall portfolio value would not be hugely affected by the loss.

Fixed Income Arbitrage

The arbitrageur takes positions in different fixed income securities, in order to exploit the relative values of the different instruments. For example, as European Monetary Union approached in the mid-nineties funds bought government bonds issued by weaker nations such as Ireland or Italy, while selling short German bonds, profiting on the convergence of interest rates in Europe. These funds have performed robustly over the last two years.

Merger Arbitrage

Merger Arbitrage, or “Risk Arb” as it is more commonly known, involves taking long and short positions in companies that are engaged in corporate mergers or acquisitions (M&A). Risk Arb funds generally buy the shares of the company being acquired and sell short the shares of the acquiring company, in a proportion which reflects the proposed merger agreement. Profits are made by capturing the spread between the current market price of the target company’s stock and the price to which it will rise when the deal is completed. These funds performed phenomenally well during the strong bull market of the 90s, when merger activity was at an all time high. With the current almost complete disappearance of M&A activity, Risk Arbitrage is probably best avoided.

Distressed Securities

The Distressed Securities strategy generally involves the accumulation of securities of financially troubled companies. These securities often trade at substantial discounts to par value and hedge funds accumulate them with the belief that they can be sold at a profit in the secondary market, or with the expectation that the company may be recapitalised, restructured or liquidated. These funds performed well in 2001, but were generally flat for 2002, as the economic situation worsened.

Global Macro

Macro funds, by definition, enjoy remarkable flexibility regarding investment and trading strategy. They take long and short positions in currencies, bonds, equities and commodities. Through their size (an estimated 15% of hedge fund assets under management) and the degree of leverage used, they are believed to influence world markets. The fund manager attempts to exploit divergences in value between and within the various asset classes. Trading decisions are based on the manager’s macro view of the world, economy, government policy, interest rates, inflation, market dynamics, and sentiment. The break up of the ERM in 1992 was attributed to these macro funds, and some of their managers, such as George Soros, became household names.

Hang on a second, I read in the investment press that hedge funds performed badly in 2002

It’s true that the industry did not perform as well in 2002 as in previous years. However, according to data provided by the CSFB/ Tremont Hedge Fund Index, an asset-weighted benchmark of hedge fund performance net of fees, the worst performing fund classification in 2002 was Merger Arb\itrage – 3.52%. The best performing styles in 2002 were the Global Macro +13.68% and Equity Market Neutral +7%. The aggregate hedge fund index was up 3%. Over the previous seven years from 1995 to 2001, the index returned an average 13% per annum.

This compares rather favourably with the ISEQ and the FTSE 100 which returned -36%, and -18% respectively in 2002, and an average of +16% and +12% respectively from 1995 to 2001. It should also be noted that the best performing Irish pension fund in 2002 showed returns of-13.9%.

How much of a portfolio should be invested in hedge funds?

Hedge funds should be seen as another asset class to add to a portfolio, along with stocks, bonds, property, etc. One of the advantages of hedge fund investing is that the returns to hedge funds typically do not have a strong correlation with the traditional asset classes mentioned above. As such, they add excellent diversification to an investors’ portfolio.

As with any new investment it is usually best to start small, and then gradually increase your portfolio allocation as you become more familiar with the product. More cautious investors could opt for a capital guaranteed product, although this can limit upside and/or carry additional charges.

Where can potential investors get more information?

Get in contact with your financial advisor or stockbroker. They will be able to provide you with information on the range of products that are available to Irish investors.

Mark HUTCHINSON is a Lecturer in the Department of Accounting, Finance and Information Systems at University College Cork. Email: m.hutchinson@ucc.ie

Copyright Institute of Chartered Accountants In Ireland Jun 2003