Hedge funds

I recently read that hedge funds are the fastest growing financial instruments in the world. What are hedge funds and would they be good investments?

A hedge fund is an investment fund charging a performance fee and is typically open only to a limited range of investors. In the United States, hedge funds are open to accredited investors only. This requires a net worth of $1 million or annual income of at least $200,000 or annual joint income (with spouse) of $300,000 for two documented years and proof that such income is expected to continue.

Due to this restriction, they are usually exempt from any direct regulation by entities such as the United States Securities and Exchange Commission.

Hedge funds seek to protect their investments against adverse market moves to achieve positive returns even during a fall in the markets. Their objective is to generate higher returns than the ordinary investor would achieve through the broader financial markets. They can follow complex strategies being long or short assets and entering into futures, swaps and other derivative contracts. Some do not trade stocks at all and instead focus on other financial instruments, including commodity futures, options, foreign currency and emerging market debt.

As payment and as an incentive to acquire returns under any market conditions, and especially during market downturns, the hedge fund manager typically receives 20 per cent of gross returns as a performance fee.

Assets under management of the hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006 according to data released by Chicago-based Hedge Fund Research Inc. This was up 19 per cent on the previous year, and nearly twice the total of three years earlier. In a separate study by Institutional Investor News and New York-based Hedgefunds.net, total estimated assets for the industry grew by 24 per cent in 2006 to a total of $1.9 trillion.

As private, lightly regulated companies, hedge funds do not have to disclose their activities to third parties, thereby gaining an advantage over ordinary funds when trading in the markets. Hedge funds are typically domiciled in an offshore jurisdiction such as Bermuda, the Cayman Islands and the British Virgin Islands where tax rates are favourable. The Cayman Islands have been estimated to be the home of 75 per cent of the world's hedge funds.

Today, the retail investor has access to participate as funds have recently been launched which invest in diverse hedge funds. These provide access to the small investor with lower risk through exposure to a large number of vehicles. Hedge funds should be considered as part of an overall portfolio due to their growing influence in global markets and as they can provide high returns with the best fund managers significantly outperforming the public markets.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 or e-mail mh@hollingsworth-int.com.