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Hedge funds, also known as absolute return funds, use alternative investment strategies that are more complex than traditional managed funds. Many hedge funds aim for positive or less volatile returns in both rising and falling markets.
Hedge funds aim to achieve returns through an investment managers skill and by using complex strategies and tools that can be riskier than traditional managed funds. Here we explain some of the risks and benefits of hedge funds.
Hedge funds are investments that use pooled funds to invest in alternative assets or strategies. These strategies may include the use of derivatives, alternative investments and leverage in both domestic and international markets.
Hedge fund returns may have a low correlation with more traditional assets, such as shares and bonds, which can make them a good way to diversify a portfolio.
Many hedge funds aim to deliver positive or less volatile returns, in both rising and falling markets. Hedge funds often have a specific benchmark such as a market index or interest rate they are trying to outperform, or they may focus on achieving a benchmark return with lessvolatility.
There are many different types of hedge funds and the features and risks of each will depend on:
You will find this information in the fundsproduct disclosure statement(PDS).
Although each fund is different, here are some tools that are commonly used by hedge funds.
Leverage occurs when a fund increases its exposure to certain assets or strategies, usually through borrowing. While the use of leverage can increase returns, it can also increase losses.
Some hedge funds use derivatives to gain or reduce exposure to certain assets, markets or events. Derivatives are securities whose value depends upon an underlying asset such as a share, commodity or index. Derivatives give investors the option or obligation to buy or sell an asset in the future based on a price agreed at the time of entering into the derivative contract.
Derivativesare used by hedge funds to manage investment risk or tospeculateon the future value of markets and assets. They can also be used to gain more efficient investment exposure to a set of underlying assets without buying the assets directly.
Short selling is a strategy where an investor borrows a security from another party (usually a broker) and then sells it on the market. At some time in the future, the investor hopes to buy an identical security at a lower price and return it to the lender, hoping to profit from any difference between the price it was bought and the price it was sold.
A long/short strategy is a common strategy used by hedge funds. This involves buying some securities which are expected to increase in value while shorting others expected to decrease in value.
Hedge funds may invest in less conventional assets, such as high yield bonds, synthetic assets, derivatives, unlisted shares and other hedge funds.
Hedge funds are usuallyactively managed. Investment managers have discretion over what assets to invest in and how much to invest into any given asset or market.
Where a fund is actively managed, the expertise and experience of the investment manager is crucial to the funds success.
Here are some of the benefits of investing in hedge funds:
– Some hedge funds may target less volatile returns, meaning they lose less in a down market. However, this may be at the expense of gains in a rising market. Some hedge funds may target higher returns even though this may put them at risk of incurring substantially greater losses. You should consider your appetite for risk when choosing a hedge fund.
– Hedge funds can expose you to a broader range of asset classes and markets, which can help to diversify your portfolio and reduce your exposure to downturns in some asset classes or markets.
Hedge funds can vary widely in their investment strategy and risks. The funds PDS will outline these strategies and risks. Here are some common risks to look out for:
– Some hedge funds have an exposure greater than 100% of assets invested, so if markets move against the funds position it could suffer significant losses. The use of derivatives and short selling involve leverage risk.
– If the fund has invested in assets that are not traded on an open market, they can be harder to trade and harder to value. They may also be harder to sell quickly if the asset devalues or you want to withdraw some or all of your money.
– If a fund has a concentration of assets in a single market there is a greater risk of incurring losses if that market underperforms.
– The more complicated the investment structure, the harder it is to work out how your money is invested and what risks you are taking on.
– Some derivatives are purchased over the counter by agreement with counterparties. There is a risk that the counterparty will fail to honour the agreement.
By law, a hedge fund manager must give you a PDS before you invest. The PDS sets out the significant features, benefits, costs and risks of the fund. Read the PDS and make sure you understand the investment before you commit your money. Consider seeking advice from a licensedfinancial plannerif you are not sure if the product is suitable for you.
Before you invest in a hedge fund, use these key questions to check your understanding of the fund:
– What are the investment goals and what strategies will be used to achieve these goals?
– Whos managing the fund and what relevant qualifications and experience do they have?
– Does the fund invest in Australian or overseas assets? If the fund invests in overseas assets, have the foreign currency risks been hedged?
– Although past performance is not a reliable indicator of future performance, it can give you an indication of how the fund has performed in both rising and falling markets. Look at medium to long-term performance over 5 to 10 years.
– If the fund uses third party service providers, are they licensed in Australia or in another country where financial regulations are less strict?
– How are the fees charged and do they provide an incentive for investment managers to take extra risks? Is the managers right to charge a performance fee subject to the fund outperforming some benchmark? If so, make sure the benchmark is appropriate. Are the returns, after fees, likely to justify any additional risks taken?
– Do you understand how the investments are structured? Could you explain it to someone else?
– How quickly can you redeem your investment from the fund? Is there a minimum amount of time your funds must stay invested? Is there a minimum redemption amount? Are redemptions subject to exit fees?
A fund that invests in other hedge funds is known as a fund of hedge funds. These funds may have only a portion invested in other hedge funds or they could invest all of your money in other hedge funds.
Generally, where a fund of hedge funds invests in another hedge fund, the underlying fund is not open to retail investors. The underlying funds may be based offshore and may not be as closely monitored as funds in Australia.
Funds of hedge funds have the same risks as investing in directly in hedge funds, as well as some additional risks. These include:
– Investments are spread over many hedge funds with investments in many assets and markets. This can make it difficult to know where your money is invested and what risks you are really exposed to.
– A fund of hedge funds may not be able to exit the underlying funds quickly, which may make it difficult redeem at short notice.
– Investors are likely to pay an extra layer of fees.
ASIC has developed disclosure benchmarks for hedge funds so that investors are better informed before they invest. To find out more read ASICs Regulatory Guide 240Hedge funds: Improving disclosure.
Hedge funds are complex investments and risks can vary widely between funds. Read theproduct disclosure statementand considergetting financial advice before you invest.