Investment returns have traditionally been measured against a market index rather than in terms of whether the investments appreciate in value or not. Absolute Return investments seek to generate positive investment returns at all times.

Hedge funds can be defined as absolute return oriented investment vehicles which utilise sophisticated investment techniques for the purpose of achieving superior risk adjusted returns. Hedge funds are often referred to as alternative investments.

The first acknowledged hedge fund was launched in 1949, although leverage and short selling had been used long before this time, but not combined in a low risk hedged model. The original model of long/short equities in the same sector has evolved into a multitude of strategies.
As at the end of the first quarter of 2003, it was estimated that there were over 5,000 hedge funds in existence worldwide with total assets estimated at over US$ 600 billion*. In the US, hedge funds have been accepted as an asset class for many years and can be found in the portfolios of pension funds, endowments and other conservative investors.
Portfolios of hedge funds, known as funds of funds, have been one of the main ways of accessing hedge funds as they have historically succeeded in reducing overall portfolio volatility and diminishing the risk of selecting an inappropriate individual hedge fund .

Many individuals in the professional investment community consider hedge funds to be speculative investment vehicles which take highly leveraged, directional bets based on broad macroeconomic or market views. This tainted image is partly as a result of articles in the press which refer to Global Macro funds such a Julian Robertson's Tiger Fund or George Soros's Quantum Fund. The Long Term Capital Management (LTCM) debacle opened the public's eyes to other forms of hedge funds and the dangers of leverage, but again distorted people's views of the industry.
The reality is that the hedge fund industry is much more diverse and, for the most part, quite conservative. Most hedge funds are specifically designed to reduce risk and limit volatility. Global Macro funds represent a small part of the hedge fund universe which contains a diverse range of investment strategies. The leverage employed by most hedge funds is modest and some use none at all. This contrasts with the exceptionally high leverage employed at LTCM.

 

As an additional benefit, the timing of entry and exit is significantly diminished as the volatility of many hedge funds is much lower than equivalent traditional investment products.

There are many different styles of hedge funds. Each of these will have different performance characteristics in different market environments. A blend of different styles of hedge funds has typically exhibited good capital preservation and positive investment performance over the two most recent strong and weak equity market cycles. Individual hedge funds exhibit individual performance and risk characteristics and need careful monitoring and evaluation.

Anecdotal evidence suggests that in the 1980's and early 1990's investments in hedge funds were predominantly made by high net worth private individuals, but that is changing and new capital flowing into this style of investment has also come from institutions ranging from corporate treasuries to pension funds and endowments.

A hedge fund is an absolute return oriented fund which has its own portfolio of investments. A fund of hedge funds invests in a number of individual hedge funds and seeks to create a diversified portfolio of funds which will deliver similar risk and return characteristics, but with a lower level of volatility.

Improved risk adjusted investment returns in the form of:

• Acceptable levels of volatility
• Capital preservation
• Investing in a pool of top international investment managers through a single fund
• Portfolio diversification

Investors reviewing opportunities in hedge fund investing should be aware that there are still risks to consider, and that there are obstacles to creating a sensibly diversified portfolio of hedge funds. Other than normal investment risk, factors to consider include the following:

• There are over 5,000 funds to select from
• Finding adequate information may not be straightforward
• There are meaningful differences in risk and return between individual funds
• These funds may not necessarily be regulated
• The fund's management team is often small and not institutionalised
• The vast majority of hedge funds only offer infrequent liquidity, monthly being typical, but six month lock-ups or even annual liquidity is not unusual

Many of the best hedge funds are closed to new investors (they are capacity constrained by their investment style) or have high minimum investment thresholds. For most investors, structuring a sensible hedge fund portfolio is not a simple process, and many investors use hedge fund selection specialists to access this sector in a controlled matter. Hedge fund selection specialists would provide ongoing quantitative and qualitative analysis of existing and potential new managers .

Most hedge funds and funds of hedge funds are Offshore Funds because they are registered or incorporated in "offshore" locations situated outside the main centres for investments (in the US and Europe). Examples of such locations are Bermuda, the Cayman Islands, Guernsey, Jersey and the Isle of Man.

Most hedge funds are established and domiciled in offshore locations where the regulation of their activities is not as extensive as funds established in the main investment centres of the US or Europe. However, most hedge fund managers are located in these main investment centres and are regulated by mainstream regulators such as the SEC in the US or the FSA in the UK.

Hedge funds and funds of funds are generally constituted as open ended investment funds. Therefore, their liquidity depends on the frequency in which they deal (i.e. issue and redeem) their shares and on any notice requirements imposed by the fund in order to deal. Most hedge funds have monthly liquidity with about 35 days notice, but some hedge funds are a lot less liquid.