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Home / New Zealand

A little bit of this and a little bit of that

22 Mar, 2002 07:34 AM3 mins to read

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So what is a hedge fund? That's a good question, as the politicians say while they struggle to come up with an answer.

Hedge funds are difficult to define. The term covers everything from ultra-conservative funds to some which are highly speculative, and encompasses a vast range of investment strategies.

It's easier
to define what they aren't; hedge funds aren't the sort of funds that simply buy investments and hold on to them for the long term.

Hedge funds tend to be much more nimble than that, and will do just about anything to make a profit.

In the United States, hedge funds go back about 50 years. The name comes from the way the original funds "hedged" or insured against a fall in the sharemarket by a technique called "short selling" - essentially, selling shares they didn't own, in the hope of profiting from a fall in the share price.

The term has stuck, even for funds which don't hedge in the traditional sense.

The people who run hedge funds sometimes refer to them as "absolute return" funds, making the point that the return they produce is not related to the overall direction of any particular investment market.

So, unlike conventional sharemarket funds, for example, hedge funds can profit even when the market keeps falling (their promoters are less likely to point out that they can also lose money even when markets are rising, but that's possible too).

Hedge funds have achieved a degree of notoriety, thanks largely to the activities of global speculators such as George Soros and the failure of Long-Term Capital Management (LTCM), a hedge fund which collapsed spectacularly in 1998.

Hedge fund promoters are at pains to stress that such high-risk operations are the exception rather than the rule, and that few funds indulge in the heavy borrowing that was the downfall of LTCM.

In practice, funds tend to specialise in particular strategies, of which there are a bewildering variety. US-based Van Hedge Fund Advisors International lists 18 hedge fund strategies and sectors.

A few examples:

* "Distressed securities" funds look for shares or fixed-interest investments issued by companies which have gone into bankruptcy or are otherwise in trouble, in the hope that the investment will gain in value when the company emerges from its difficulties.

* "Macro" funds look for international trends, in the hope of profiting from changes in things such as interest rates or currency values.

* "Special situations" funds react to news - good or bad - which is expected to result in a rapid change in the value of shares or fixed-interest investments.

* "Short selling" funds scour the market for overvalued shares. They then borrow those shares and sell them, in the hope of buying them back later at a lower price.

There are many other strategies, and some managers combine several.

Though hedge funds vary widely, one similarity is in the way they charge; on top of an annual management fee they typically take 20 per cent of any profits, after making good any earlier losses.

Hedge funds which are offered to smaller investors tend to be "funds of funds". That means the overall fund manager spreads investors' money among a number of funds - often as many as 30. The logic is that it spreads the risk over several managers, and a number of different strategies.

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