Hedge funds key for client returns as equity and bonds fail

Hedge funds are now crucial for wealth managers trying to make their clients money in tough times says Iain Tait

The UK has emerged from the financial crisis remarkably well; Central Bank measures such as quantitative easing (where the Central Bank prints more money as a way to lower interest rates, encouraging people to spend rather than save and therefore keep the economy moving), have encouraged growth and prevented the kind of catastrophic slump that countries like Spain and Greece experienced. However, the flipside is that investors simply do not make the same amount of money on their savings that they had been used to previously.

What we’re seeing now is the effect of these Central Bank policies waning, but we’re stuck with near-zero interest rates and traditional safe haven asset classes (bonds, cash) still aren’t delivering the returns they used to. And on top of this is the ongoing market volatility – barely a day goes by when we don’t see headlines warning of more stock market woes. Equities, whilst more likely to give you better returns, will be a bumpy ride.

One approach that can combat this is use of hedge funds.

Hedge funds have the ability to deliver positive returns that are not linked to those traditional asset classes of equities, bonds and cash. January demonstrated how resilient hedge fund strategies can be. Despite widespread volatility in the global markets, select hedge funds performed positively. CTA funds (Commodity Trading Advisors) for example have done particularly well of late due to their short energy and equity exposure, meaning they took bets on the price of energy falling.

Hedge fund strategies are increasingly accessible and have become a more viable option for investors. A number of European domiciled UCITS (Undertakings for Collective Investments in Transferable Securities) hedge funds have been launched in recent years. These UCITS hedge funds have tighter risk management restrictions and a greater focus on liquidity. The UCITS regulatory framework addresses some of the liquidity concerns investors may previously have held towards hedge funds and the lower minimum investment thresholds have removed another historic constraint to using them. The reduced risk associated with these funds makes them more attractive, as does the greater liquidity as it means the capital invested is more accessible and easier to redistribute should markets change.

However, investors should remain cautious and not be tempted into taking unsuitable risks in order to try and achieve the returns they were previously used to. Tighter regulations are no substitute for thorough investment, operational and legal due diligence – the distribution of returns across hedge fund strategies can vary significantly.

Last year, despite flat performance across the industry in general there were a number of hedge fund strategies that did rather well. Long/short equity, equity market neutral and fixed income arbitrage delivered some of the best returns in 2015, but despite a good number of managers delivering positive returns the difference between the top and bottom performers was still significant. This is a warning for anyone considering going down the hedge fund route that for every good performance, there is likely one that has not delivered those all-important solid returns. For example, the long/short equity strategies returned an average of 3.6 per cent, but breaking that down, top quartile performance was 6.4 per cent and bottom quartile was -6.4 per cent.