Hedge your bets
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
manager's 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.
What are 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 less volatility.
Typical features of a hedge fund
There are many different types of hedge funds and the features
and risks of each will depend on:
- the fund's strategy
- the types of assets it invests in
- where the assets are located
- the investment tools used
- the managers' skill and knowledge
You will find this information in the fund's product disclosure
Although each fund is different, here are some tools 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.
Derivatives are used by hedge funds to manage investment
risk or to speculate
on 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.
Alternative assets and investments
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 usually actively 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.
Benefits and risks of
Benefits of hedge funds
Here are some of the benefits of investing in hedge funds:
- Targeted strategies - 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.
Investors should consider their appetite for risk when choosing a
- Asset diversification - Hedge funds can
provide investors with exposure to a broader range of asset classes
and markets which can help to diversify their portfolio and reduce
an investor's exposure to downturns in some asset classes or
Risks of hedge funds
Hedge funds can vary widely in their investment strategy and
risks. The fund's PDS will outline these strategies and risks. Here
are some common risks to look out for:
- Leverage risk - Some hedge funds have an
exposure greater than 100% of assets invested if markets move
against the fund's position it could suffer significant losses. The
use of derivatives and short selling involve leverage risk
- Liquidity 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 an investor wants to withdraw some or all
of their funds.
- Concentration risk - If a fund has a
concentration of assets in a single market there is a greater risk
of incurring losses if that market underperforms.
- Complex structure risk - 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.
- Counterparty risk - Some derivatives are
purchased 'over the counter' by agreement with counter parties.
There is a risk that the counter party will fail to honor the
Read the PDS
A hedge fund manager is required by law to give you a product
disclosure statement (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 licensed financial planner if you are not sure if
the product is suitable for you.
Things to consider before investing
in hedge funds
Before you invest in a hedge fund, use these key questions to
check your understanding of the fund:
- Strategy - What are the investment goals and
what strategies will be used to achieve these goals?
- Investment manager - Who's managing the fund
and what relevant qualifications and experience do they have?
- Local or international - Does the fund invest
in Australian or overseas assets? If the fund invests in overseas
assets, have the foreign currency risks been hedged?
- Past performance - Past performance is not a
reliable indicator of future performance, however, 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
- Third party service providers - If the fund
uses third party service providers, are they licensed in Australia
or in another country where financial regulations are less
- Fees - How are the fees charged and do they
provide an incentive for investment managers to take extra risks?
Is the manager's 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?
- Structure - Do you understand how the
investments are structured? Could you explain it to someone
- Redemptions - 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?
Fund of hedge funds
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
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.
Risks of fund of hedge funds
Fund of hedge funds have the same risks as investing in directly
in hedge funds, as well as some additional risks. These
- Exposure - 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.
- Liquidity risk - A fund of hedge funds may not
be able to exit the underlying funds quickly, which may make it
difficult redeem at short notice.
- Extra fees - Investors are likely to pay an
extra layer of fees.
ASIC's work to improve hedge
ASIC has developed disclosure benchmarks for hedge funds so that
investors are better informed before they invest. To find out more
read ASIC's Reg Guide 240 Hedge funds: Improving disclosure.
Hedge funds are complex investments and risks
can vary widely between funds. Read the product disclosure
statement and consider getting financial advice before
Last updated: 01 Feb 2016