Your Money Matters: Reducing exposure in today's volatile markets through hedge funds

Last week, China's stock market drop precipitated a snowball effect, causing a decline in most equity markets worldwide.

By AARON LEITNER
Last week, China's stock market drop precipitated a snowball effect, causing a decline in most equity markets worldwide. This is the second time in 12 months that we have seen a sharp global stock market sell-off after a period of substantial gains over a relatively short period of time. One can assume that more bumpy rides are ahead of us as the US is no longer the only equity market that can lead global markets up or down. Nevertheless, my view for 2007 has not changed; equities will produce positive returns and significantly outperform bonds. But not all investors have the appetite for volatile market swings. In my last article, I wrote about risk. Last week's market declines illustrated my point regarding defining a portfolio's downside risk profile. Sophisticated individual and institutional investors have been using hedge funds as a tool for reducing portfolio volatility for many years already. Why hedge funds? Hedge funds allow for greater diversification in portfolios and usually have a low or negative correlation to such traditional investments as stocks and bonds. They may provide positive returns in periods when other asset classes' performances are negative. Hedge fund managers are experts in specific strategies, and will take advantage of market disparities and inefficiencies. The managers are normally key in the excess returns (alpha) they achieve against traditional benchmarks. Hedge funds also provide a vehicle for exposure to more exotic investments such as foreign currencies, commodities and futures. Hedge fund managers are opportunistic and seek to benefit by inefficiencies in the markets. Hedge funds generally define their objectives as an absolute annualized return within a defined volatility (standard deviation) range. Hedge funds do not try to mirror or beat a defined traditional benchmark though they may publish one to provide a context for their performance and volatility. In the last 16 years the number of hedge funds has grown from 610 to close to 9,000, according to data from Hedge Funds Research Inc. Investors may choose from two distinct universes of hedge funds; one is the single manager fund and the other is the multi-strategy and fund of funds manager. What's the difference? A single manager fund is an investment in one fund manager with a defined hedge fund strategy. There are various strategies due to the fact that most hedge funds require minimum entry investments ranging from $50,000 to $1,000,000 or more; only larger portfolios will hold a group of single manager funds. Single strategies include long/short equity, distressed securities, global macro, commodities, event driven, market neutral, fixed income and convertible arbitrage. For most first- time and smaller investors, funds of funds and/or multi-strategy funds are a serious alternative to a single manager investment. Multi-strategy funds and fund of funds offer provide pool multiple managers and strategies into a single fund. They provide greater diversification across strategies and investment disciplines. These types of hedge fund investments have a high negative correlation among funds assuring investors that one fund's losses may be offset by another's gains; substantially reduce volatility. Multi-strategy funds employ the same single fund managers of the parent hedge fund company. There is a fund manager who actively manages the fund's sub managers and monitors risk and the amount of funds allocated to any one manager. A fund of funds is different from a multi-strategy fund because the underlying fund managers are outside managers and not owned by the fund of funds' hedge fund company. This structure allows investors to access a basket of funds in which they would not be able to invest due to minimum investment requirements. It also allows for greater selection and replacement of the sub managers since it is not confined only to the hedge fund company's managers. The negative is that the internal management fees will typically be higher in a fund of funds versus a multi-strategy fund. Hedge funds have characteristics that investors need to be aware of. Most hedge funds offer limitations on liquidity. The restriction on selling a hedge fund investment may range from weekly, to monthly, to semi-annually or more. It is important to know what these restrictions are before investing. Also, hedge funds are not as regulated as mutual funds and are less transparent to investors. This makes it more difficult to analyze the fund and its manager for investment risk related issues. Generally, it is advised to work with an entity that has the capability to conduct due diligence reviews and additional screens on fund managers in order to receive objective performance analysis and hedge fund manager recommendations. aleitner@tandem-capital.com The author is Global Investment Strategist at Tandem Capital