What are alternative investments?

Alternative investments exist outside the mainstream markets, enabling lower risk and greater returns. Their performance is down to the skill of the fund managers in generating returns and defending gains in both rising and falling markets. Managers use a variety of investment strategies in diverse markets to target absolute performance and offer attractive risk-adjusted returns.

Initially devised in the US in 1949, hedge funds really took off in the late eighties, and have since evolved into mainstream investment products that now form a key part of both institutional and private client portfolios. Today’s hedge funds offer greater choice and exposure to a larger variety of investment styles, strategies, instruments and techniques.

How do hedge funds differ from traditional investments?

Traditional asset managers typically allocate capital to cash, bonds or stocks, and profit if these rise in value. Hedge fund managers invest in a range of financial instruments on both the long and short side.

The ability to ‘go short’ (for example selling a share with the intention of repurchasing it later at a lower price), allows managers to profit from a decrease in share value. Similarly, managers can construct a basic hedge by purchasing undervalued shares, and can therefore profit in both rising and falling markets.

Hedge funds are usually included as a medium to long-term investment in a traditional portfolio of stocks and bonds. The weighting of hedge funds in a portfolio depends on the investor’s diversification requirements and the mix of styles and strategies within the portfolio.

Key features of hedge funds:
  • Absolute returns – hedge fund managers pursue absolute returns rather than returns relative to an index or benchmark, allowing them to generate gains even when the traditional markets are failing or range bound.
  • Skill-based strategies – returns of hedge funds are derived mostly from the skill of the hedge fund manager in executing their chosen strategy rather than relying on asset appreciation in rising markets.
  • Flexibility – hedge funds have the ability to trade on the long and short side of various financial instruments.
  • Diversity – hedge fund managers trade across a spectrum of markets and exchanges, investing in a diverse array of financial instruments including equities, bonds, currencies and derivatives.
  • Alignment of interest – hedge fund managers often invest their own money, which aligns their interests with those of their investors.
Funds of hedge funds

Funds of hedge funds allocate to a number of different hedge fund managers and strategies to create diversified portfolios that aim to deliver more consistent returns than individual hedge funds.

A fund of hedge funds manager will employ a clear investment process and methodology to harness each underlying investment style within a portfolio. Anticipating potential problems in capitalising on new opportunities requires expert due diligence, style selection, portfolio construction, manager monitoring and risk management.

Many people think that hedge funds are too risky, lack liquidity, are run with little transparency and are the preserve of high-net worth investors. In reality, today’s products offer a broad and diverse range of risk profiles and styles, with liquidity provided by third parties. Fund of funds providers attract many private investors, and transparency is improving all the time.