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Wed 8th September, 2010
News
The saying "too good to be true" was not invented for nothing |
28th June 2005 |
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Over the past few years hedge funds have gained acceptance to the point where not only are they included in growing numbers of portfolios, they are almost considered an asset class in their own right! Historically, allocating investments produced a conventional choice between bonds, equities and cash. But the need to extract performance during and after the 2000-2003 bear market induced conditions suitable for the phenomenal growth of the hedge fund industry. The fourth Hedge Fund Manager Bi-Annual Hedge Fund Administrator survey indicates assets under management have grown from $745bn in November 2003 to $1.9trn as at May 2005.
The falling returns of traditional asset classes during the bear market is the main reason for the elevated status of hedge funds. Opportunities were seen in hedge funds, which are able to exploit techniques such as short-selling and leveraging to manage risk. Product innovation has resulted from this increased investor appetite and this in turn has stirred the regulatory community. Taking centre stage are funds of hedge funds, which have outpaced the investments flowing into single-strategy funds. The survey reports growth in funds of hedge funds of 26.52% compared with 22.62% in single-strategy funds over six months to May 2005, even despite recent losses.
The concept behind using funds of hedge funds is that in addition to reducing portfolio risk through diversification, they can deliver more stable returns through variable market conditions and eliminate the due diligence required in single-strategy investing by providing access to a larger range of hedge funds that may otherwise be restricted through high minimum investments. Standard & Poor’s in London say that a number of advisers are allocating as much as 20% of assets at their disposal to funds of hedge funds. European insurance companies and pension funds have allocated billions of euros to hedge funds.
The offshore domicile of many hedge funds has circumscribed their attractiveness to European investors as they fall into a higher-risk category under many regulatory regimes, even if it has the same characteristics as funds based in Europe. Despite the industry’s attempts to create a more integrated European fund market, barriers to cross-border trade are still very much in place. Conventional equity and bond funds are “passportable” under Ucits III and they can be sold in all EU member states. But hedge funds are not Ucits III-compliant and have to be individually authorised in each country. In my view, this is not a bad thing!
The tools for analysing hedge funds are nowhere near refined as those for equities and bonds. For those who require research and information on listed securities, information is both detailed and easily accessed. In response to growing demand for independent information S&P launched its qualitative interview-based ratings service for funds of hedge funds in May 2004. Hedge fund managers often manage the fund as well as run the business. Therefore S&P analysts are having to pay much greater attention to the hedge funds teams due diligence process. Many fail to achieve an S&P rating not because of investment capability, but because something came unstuck in the back office.
The proliferation of hedge funds and funds of hedge funds will inevitably increase demand for transparency, detailed reporting and proper regulation. But when this happens, both advisers and investors will have no option but to face facts in respect of the true levels of risk taken within such funds. The reason why I have no time for hedge funds or funds of hedge funds is simple, there is no such thing as financial alchemy.
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