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Hedge funds are complex, risky, non-transparent and illiquid?

Posted by Etienne Baume on

Confidence in hedge funds has suffered as a result of the financial crisis in 2008/09. A few hedge funds have taken on too much risk and have not survived the crisis.

Of course Madoff’s Ponzi scheme did not help the reputation of hedge funds, when he swindled thousands of shareholders out of $65 billion by paying early investors with the money from later investors.

As a result, many investors have written off hedge funds. It is often forgotten that some hedge funds have managed the financial crisis better than traditional investment funds.

Let’s look at some common misconceptions about hedge funds.

Complexity

While some hedge fund managers use complex instruments, the most popular strategy, long/short equity, uses the same types of securities as traditional funds such as shares and bonds. The only difference is that a long/short equity hedge fund not only buys securities that are believed to be undervalued, but also short-sells securities that seem overvalued. Taking a short position means that an investor simply borrows a security rather than buying it. The reason behind it is quite simple. If the security decreases in value, the investor can buy it back at a lower price, return the security to its owner and cash in the difference. This gives hedge funds the flexibility to profit from falling markets.

Risk

The additional toolset, which hedge fund managers use, can make a strategy more complex and harder to comprehend for traditional investors but it would be unfair to say that this leads to higher risk. Many managers use the tools to manage their risk rather than increase their returns.

The ultimate goal behind buying and holding undervalued securities and shorting overvalued ones is to minimize market exposure and to profit from changes in the spread (the difference) between the securities. So a real hedge fund is not risky due to its complexity. Rather, it is complex because of its risk management. Hence, many experts recommend adding hedge fund positions to a portfolio to diversify and reduce risk.

Transparency

Another feature of hedge funds is that they do not have to disclose their positions and investment strategies fully.

Fund managers fear losing their competitive edge should they disclose their positions and strategy. The opposing view is that given many endowments and pension plans are invested into hedge funds, the public has the right to know how their pensions are being invested, to ensure they are with responsible managers and in secure assets.

In recent years multiple regulatory changes have been implemented to increase transparency.

Illiquidity

Some hedge fund strategies invest in securities that are less liquid than traditional stocks. One example is distressed debt securities (securities such as corporate bonds, bank debt and trade claims, of companies that are in some sort of distress. In other words, those heading toward or already in bankruptcy).

One of the main reasons for stricter withdrawal or redemption conditions of hedge funds compared to traditional funds is that such strategies don’t realize a return right away. Even strategies that buy and sell liquid assets, such as long/short equity, don’t often realize a profit right away. They are required to wait until the expected revaluation happens and they can sell their long positions or buy back securities they sold short.

Hence, if a manager needs to sell one of his investments at an unfavorable time in order to pay back an investor, the fund performance suffers.

Nevertheless, the increased focus on liquidity and regulatory aspects led to the creation of UCITS hedge funds. The UCITS standards require a minimum two-week liquidity and are increasingly used by hedge fund managers to market their funds in European investors.

tl;dr

To sum up, hedge funds are not as bad as their reputation suggests. Needless to say, the quality of a hedge fund depends on its manager and his capabilities. As in any other market, the challenge is to find the best and weed out the rest. Since you are reading this, I assume you know what Fundbase is. If not, it’s about time. We provide investors intelligent access to diversification and return benefits of the global hedge fund market. Our work and tools yield superior transparency, manager selection and efficiency that were previously unavailable to many investors.


Etienne Baume

Etienne is a Product Manager at Fundbase.