Confusion and complexity surrounding hedged or alternative investment strategies can prevent investors from choosing these strategies – instead, they are favoured by institutional investors or super funds. But there are clear opportunities and advantages in incorporating alternatives into your portfolio.
Hedge funds hold a wide range of connotations for investors. From their beginnings in the 1960s, through their heyday in the late 1980s and during their subsequent fall from grace in the late 2000s, hedge funds have variously been among the best-performing investment vehicles.
Australian-born Alfred Jones is credited as the father of the hedge fund, launching the first iteration of the long/short equity fund in 1948. In those early days, the aim of a hedge fund was a simple one, focused on managing risk through the use of hedging strategies. The modern hedge fund, however, is commonly considered to be a much more complicated beast.
One product that sets hedge funds apart from traditional investing is a focus on absolute returns rather that returns relative to a benchmark – or an index such as the ASX.
Equity-based hedge fund strategies can retain more flexibility, focusing on preserving your capital and hedging against market falls.
An alternative Investment comprises an eclectic mix of investment strategies and structures, which serve the common purpose of diversifying an investor’s portfolio. This might mean exposure to an asset class that demonstrates little or no correlation to other assets in the portfolio.
Alternative equity strategies seek to deliver absolute returns that are uncorrelated to the underlying share market, using equities and equity-based derivatives as the component assets of their portfolio.
These funds employ varying degrees of hedging as part of their investment strategy to amplify, limit or eliminate an investor’s exposure to movements in the broader share market, known as market beta. Common alternative equity strategies found in the Australian marketplace include variable beta and market-neutral funds.
Hedging strategies allow an investor to retain an exposure to securities that offer the prospect of returns greater than an investment in cash, while managing risk. The short-selling of securities is the principal means of hedging an investment portfolio.
In this way, a long/short fund manager will buy securities they expect will become more valuable through time and short-sell securities that are overvalued or whose value is expected to deteriorate. The process used in constructing a shorts portfolio is exactly the same as the process we employ in constructing the longs, except everything is in reverse.
In holding long and short positions at the same time, a long/short investor takes advantage of the natural hedge, and the effect of macroeconomic forces that impact on the market as a whole can be managed.
An economic shock, such as a local stock market crash or a global financial crisis, that causes the price of all shares to fall together results in losses as the value of long positions fall and gains from the concurrent reduction in the size of liability associated with short positions. The effect of these exogenous forces on a long/short investment portfolio is therefore reduced or eliminated, depending on the amount of hedging in place.
As the amount of hedging in a portfolio increases, the impact of market beta is reduced, which works against a long/short investor in rising markets. Stock selection therefore is a critical component of a successful long/short equity strategy, which cannot rely solely on rising asset values to generate returns.
Like any investment, alternative equity strategies have their own risk/reward dynamic and must be weighed on their merits. Statistical analysis has shown, however, that returns from these strategies have little or no correlation with the broader share market or in fact with each other.
As such, they are one of the few investment options that offer investors genuine diversification in a portfolio. Coupled with their focus on capital preservation and potential to deliver positive returns in all markets, alternative equity strategies are a worthwhile consideration.