Make no mistake about it – financial markets are becoming increasingly complex. So much so that savvier investors are delving into their toolkits in search of unconventional ways of managing their investments.
While professionally managed vehicles such as mutual funds have traditionally dominated the retail investment space, non-traditional asset classes such as hedge funds are gaining in popularity as investors look for new ways of meeting their investment goals or objectives. What is a hedge fund and how does it differ from a traditional mutual fund?
Before examining the key similarities and differences between mutual funds and hedge funds, it may be useful to put the current market context into perspective. This way, one could determine why non–traditional asset classes such as hedge funds may be a suitable addition to a conventional portfolio of stocks, bonds and mutual funds.
Markets are becoming more and more volatile
Rounding up the year’s key headlines, Greece was surely the talk of the street. At the turn of the year’s midway point, investors were busy weighing the prospects of a sovereign default, as negotiators failed to seal a bailout deal after Greece defaulted on a €1.6 billion payment in June. Since then, an arrangement has been made, but who is to say the risk of a “Grexit” won’t creep back into headlines?
Meanwhile, central banks in Europe, China and Japan continue to deploy stimulus measures to kick-start their ailing economies while in North America, investors are bracing for a much-anticipated rate hike by the U.S. Federal Reserve. Elsewhere, the Bank of Canada has engaged in its second rate cut in over six months, as disappointing data on the economic front revealed that Canada may be on the verge of a recession (defined as two consecutive quarters of GDP contraction). On the commodity front, WTI oil is still trading well below last year’s summit in June, ending the first half of 2015 at around $60 per barrel and pulling back to around $45 per barrel twice during that period.
Some experts believe that growth will continue to remain sluggish in the latter half of the year, making good investments hard to come by. Geopolitical tensions (such as the “Grexit” issue) can also increase the volatility of investment returns and cause fluctuations in the value of one’s investments. In that sense, never before has a professional active manager been such an important part of the equation. A professional portfolio manager is likely to be better equipped to find “hidden gems” in this low growth environment, where opportunities may be limited. Furthermore, a professional will likely have the tools needed to properly diversify one’s portfolio and mitigate the effects of volatility – in the event of geopolitical turmoil.
Why outright investments in traditional asset classes may not be enough
U.S. bond yields are near rock-bottom levels and the path to interest rate normalization is expected to be gradual at best. Given the fact that interest rate increases should be slow and steady, investors may need to consider non-traditional investment vehicles such as hedge funds to give their portfolios a little upside potential in a low yield environment. With regards to stocks (mainly in the U.S), they have been soaring for more than six years now, prompting some investors to question whether valuations are becoming stretched.
With looming interest rate increases likely to exert some downward pressure on bond prices, and stocks at risk of a pullback, investors need to find innovative ways of diversifying their portfolios and capitalizing on market opportunities. This is why hedge funds could be a good complement to an existing portfolio of traditional investments.
What is a hedge fund?
In simple terms, a hedge fund is a professionally managed investment portfolio. Like a mutual fund, it pools capital from a large number of investors and invests these funds in a wide range of financial instruments.
What are the differences between a hedge fund and a mutual fund?
Despite their name, hedge funds do not necessarily “hedge” their positions. In fact, hedge fund managers can choose to hedge their positions or not, depending on the strategy they implement.
The differences lie in the type of financial instruments used, the range of strategies that are employed by the investment manager, the way performance metrics are evaluated, transparency, regulation, accessibility to investors and fees.
Summary of key similarities and differences
|Key Features||Mutual Funds||Hedge Funds|
|Professionally managed portfolio||X||X|
|Pooled fund that invests in a variety of investment vehicles||X||X|
|Access to unconventional strategies/greater universe of financial instruments||X|
|Greater risk-adjusted return potential||X|
|Accessible to general public||X|
|Performance measured relative to benchmark||X|
|Seeks to generate highest return possible||X|
|Restricted access (accredited or sophisticated investors)||X|
With regards to the type of financial instruments and strategies that are used, hedge funds can invest in a variety of financial instruments (such as derivatives) whereas mutual funds are generally limited in terms of their selection universe. Secondly, unlike mutual funds, hedge funds are permitted to use leverage – which could amplify gains (and losses) and make hedge funds inherently more aggressive than mutual funds.
The performance of hedge funds, unlike that of mutual funds, is evaluated based on absolute return, rather than a comparison to a specific benchmark or index. That being said, it is an investment vehicle that seeks to attain the highest return possible in all market conditions.
With regards to transparency, accessibility and regulation, hedge funds are only reserved for accredited investors – usually sophisticated investors that are fully aware of the risks of investing in a hedge fund. As such, regulation is not as stringent as it is for mutual funds, which are sold to the general public and are therefore required to provide much more disclosure. As a result of fewer regulations, hedge funds are not required to disclose all of their activities, making them less transparent.
Lastly, with regards to fees, hedge funds generally charge a management fee (based on a percentage of net asset value) and a fee based on the fund’s performance. Applicable to almost all hedge funds, a “high water mark” puts a constraint on performance fees in that the manager is only paid if all losses in previous years have been recovered. Also, ‘hurdle” fees” are sometimes imposed on performance fees, which ensure that fees are only paid on the portion of performance that surpasses that of a benchmark rate. Sometimes a redemption fee is also charged, usually when an investor withdraws funds in a specific period or when withdrawals exceed a predetermined percentage.
In contrast, mutual fund fees are typically summed up in the management expense ratio (MER) – which incorporates all the operating expenses associated with managing the mutual fund, along with the fund’s management fees.
Do hedge funds increase diversification potential?
There is some evidence that suggests hedge funds are uncorrelated or less-than-perfectly correlated with the stock market. One of the reasons behind this is that with hedge funds,
there are typically no long-only restrictions on positions. This ability to take on both long and short positions can potentially enhance returns in all market conditions. This could suggest that hedge funds provide diversification benefits.
In closing, while hedge funds could prove to be a suitable addition to your portfolio of traditional asset classes, it is important to fully understand the risks of investing in this vehicle before considering it as part of your strategy. Hedge fund managers’ access to a greater universe of investment vehicles and strategies could offer great upside potential that may complement your portfolio. However, as with any other asset class, putting all your eggs in one basket limits overall diversification. As such, investors are urged to take a cautious approach to investing in hedge funds – especially if one does not fully understand the relationship between risk and return or is intolerant to potentially large fluctuations in investment returns.
Speak to your investment advisor about the best way of incorporating this asset class into your portfolio!