Tower Managed Funds says that investors are increasingly incorporating hedging funds into their investment portfolios in an effort to smooth out returns in a difficult investment climate. Up to 5 - 10% of some investors' overall investments are now in these funds as familiarity with them moves them into mainstream investment decisions.

Maximise return - minimise risk
The primary objective of a hedging fund is to maximise return and minimise risk - achieving capital growth irrespective of the conditions in the share and/or bond markets, while controlling all risk factors as much as possible. Successful hedging funds - sometimes referred to as trading funds - are offered by experienced fund managers who utilise their knowledge, experience and understanding of markets and economics to pursue opportunities in buying and selling bonds, currencies, commodities, shares, options and futures markets.

The objective for a hedge fund manager is to generate absolute returns independent of the conditions in the financial markets. Fund managers typically allocate a portion of funds to cash (or equivalent assets) before investing the remainder using financial instruments such as forward contracts, swap contracts, options and futures to take long or short positions in particular markets.

A good hedging strategy will potentially provide the investor with safe leverage and healthy returns, widening a portfolio's investment opportunities while helping to increase returns.

The ability of hedging funds to diversify portfolio risk further enables them to stand out as a valid additional asset class. Statistical measurements, used to compare volatility (risk) of different asset classes, show that hedging funds can have relatively lower risk than shares.

Performance in different market conditions

These three graphs clearly illustrate the performance of hedging funds - in this case, a trading fund - in three different market environments. In both favourable markets (such as the bull market of 1993) and less favourable times (such as during the sideways performance of 1992 and the 1987 market correction), the growing attraction of including these types of funds in portfolios becomes clear.

 

Planning an effective investment portfolio is all about maximising return - not only by investing in assets that have the potential to do well, but also by "covering the bases" to ensure that if one sector does not perform well, then the negativity is eliminated by better returns elsewhere. This is the fundamental reasoning behind having hedge funds as part of a balanced investment portfolio.

There is little doubt that the rewards and reduced volatility offered by hedge funds can be significant.

Summary: Advantages of Hedge Funds in a Balanced Portfolio

• The performance of hedge funds compares well with other asset classes over the longer term.
• Hedge funds have a low performance correlation to all other asset classes, particularly during market downturns.
• Hedge funds have shown low variability of returns compared to returns from equity funds. A combination of hedge and equity funds diversified on an international basis can provide a more efficient investment portfolio.