(Fundsupermart.com) Licensed hedge funds are now finally here. These funds were previously only accessible to millionaires through private bankers. George Soros was perhaps one of the most famous names behind hedge funds with his Quantum hedge funds and their association with the Asian currency crisis.

WHAT'S A HEDGE FUND?

Firstly, what is a hedge fund? And what are the key differences between hedge funds and the more traditional equity and bond funds? A hedge fund is measured by its absolute performance rather than relative. Equity funds can point at benchmark indices and say they outperform. But for a hedge fund, the most important thing is to produce a good absolute return. And a hedge fund cannot blame a depressed market for poor performance because, theoretically speaking, it can make money even during market crashes! A hedge fund can do this because it uses a wide range of instruments which normal funds do not use. Derivatives and swaps are some of the instruments often used.

Hedge funds are usually not restricted to any particular market. And they can invest in everything from bonds, stocks, to currencies, and even commodities. They are also allowed to leverage through the use of borrowed capital. This leveraging means that, for example, with $1 million, they can up that to $5 million through borrowing, so that they can take larger positions. This means that while hedge funds can win big, it is possible for them to lose big too.

DEFINED BY STRATEGIES

Hedge funds are usually better defined by their strategies than by their investment objectives because they have so few restrictions. There is a wide range of strategies including Relative value, Event driven, and Opportunistic styles. Examples within these strategies include merger arbitrage, where fund managers take advantage of small price differences between the buyout price of a merger and its current traded market price. There is also the distressed securities style where a hedge fund manager looks for and buys companies in bankruptcy with worthwhile assets.

There are also the macro styles made famous by George Soros. His Quantum funds are so large they can move currencies. Finally, the most common hedge fund is the long/short equity hedge fund. It makes use of derivatives to benefit from movements in the equity stock markets - be they up or down. It also typically shorts the market when the manager believes the outlook to be negative. By shorting the market, the hedge fund manager sells stocks he does not have and buys them back from the market when they are lower to fill up the outstanding positions he has.

SKILL OF MANAGER IS KEY

The attraction of hedge funds is that they are theoretically able to make money even during bad times, like now. Indeed, in each one of the strategies mentioned above, there is a wide range of returns. Thus, the skill of the manager is the key factor which determines the hedge fund's success and failure. Herein lies the most important thing investors should know about hedge funds: everything rides on the manager's skill. This is unlike traditional equity funds where you can take a certain view and be rewarded for it. For example, if you feel that the US stock market is going to rise significantly over the next 2 to 3 years, you can buy into a US equity fund and if your view is correct, chances are you will make money even if your US fund is not quite the best fund out there. However, for a hedge fund, the manager must be correct in his investment decisions for you to make money. Effectively, all you need to worry about is whether your hedge fund manager is doing his job. If he is, no matter which direction the markets were going, you would still make money. If he was not, then you could lose money even in a bull market.

One of the risks of hedge funds is that any one hedge fund usually has one strategy it specialises in. The strategy which a hedge fund manager uses might have served him well previously, but may be currently flawed in the prevailing conditions. Thus, it is much more risky to put all your money in just a single-style hedge fund. This is where the fund of hedge funds comes in.

ABN AMRO'S FUND OF HEDGE FUNDS

The fund of hedge funds recognises the difficulty that investors have in deciding which hedge funds are well run, and which are not. Thus, it chooses for the investor the best hedge fund managers it can find, and more importantly, splits the investment money amongst these hedge funds. So while an individual hedge fund may be highly risky, collectively, these hedge funds can give an investor equity-like returns with a lower volatility than equity markets.

Why would investing in over 20 high-risk hedge funds give you a lower-risk product? The answer to this is the low correlation they have with each other. At any one time, out of say 20 invested hedge funds, 10 may be holding their value, or giving a small gain, 5 may be giving 20% returns, and there could be 5 which can be producing up 40 to 80% returns. Thus, the good performers will more than make up for the slackers. And because these hedge funds have differing styles and invest in a wide range of markets, they generally do not all go down collectively the way equity markets can fall during a market crash.

A further advantage of holding such a fund is that it has a very low correlation with equity markets. The motherfund of the ABN AMRO Multi Strategy Fund, for example, has risen by 16.5% over the last 25 months since its inception to end May 2002. In contrast, the S&P 500 stock index has fallen by some 19.6% instead. The fund has been steadily rising over the past 2 years, in sharp contrast to the US market's decline. The fund has also been far less volatile than most equity markets.

A third advantage that such fund of hedge funds would have is their being able to switch to a heavier weighting for funds with strategies which may be more succesful at the moment. For example, over the last 2 to 3 years, the hedge funds specialising in the merger and acquisitions strategies were very successful because there were a huge number of mergers and acquisitions during the bull market. Now, mergers and acquisitions are few and far between, and thus, the ABN AMOR Multi Strategy Fund has been moving out of these. On the other hand, because of the downturn, there has been many more distressed companies and bankruptcy filings. Thus, the hedge funds specialising in these areas are seeing increasingly attractive deals. The fund of hedge funds can move to hold a higher weighting in hedge funds specialising in this area because it holds several hedge funds rather than just one. (ABN AMRO Multi Strategy fund holds 26 hedge funds in its portfolio currently).

The target objective of the ABN AMRO Multi Strategy Fund is to consistently achieve an absolute return of 10-12% per annum. The fund has a performance fee of 15% of the difference between its monthly returns and the one month Libor (currently 1.8%). There is also a high water mark for this which means that if the fund achieves, say $1.50 and then drops below that for the subsequent months, it will not collect performance fee for the months below its previously highest level. The fund has an annual management fee of 1.75% (1.25% - underlying fund, 0.5% - feeder fund). The initial subscription amount has been set at $100,000. One further thing to note would be that the pricing of the fund is done only once a month because it takes a long time for all the underlying hedge funds to be properly valued.

CONCLUSION

In conclusion, we feel that this is a good time to introduce such new products to Singapore. Hedge funds, especially when managed by a good fund manager, are a worthwhile addition to a portfolio as they have a very low correlation with stocks or bonds, and can be expected to perform consistently well through good times as well as bad, and with a lower volatility to boot.

Performance of ABN AMRO Multi Strategy Fund (motherfund) Over 25 Months (as at end May 2002)

All performance figures were derived by comparing bid-to-bid prices with dividends reinvested. No action should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Please read our disclaimers.