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Tuesday August 21 2018
 
Beat the Bear

Financial Mail  October 2, 1998

by Dion Friedland

 

      It was the best of times, It was the worst of times. For most investors, the last decade has been good except for July and August this year, when there was a bloodletting. But if you were the Princeton Global Fund, the bearish months were a boom.

       Princeton gained more than 60% in this two-month span by shorting global markets. Unlike unit trusts and mutual funds, which typically invest long, Princeton is a hedge fund and has the flexibility to use alternative trading strategies to respond to market changes. It is an extraordinary example of what a hedge fund can do, relying on the investment expertise of Princeton Economics International, perhaps the largest global investment advisory and research firm in the world. Princeton's 300 employees and thousands of clients, which include governments, banks, brokers and institutions, benefit from its research and investment process. This relies on the data generated by its US$60m artificial intelligence system tracking more than 30 000 financial statistics daily and comparing them to data that may go back 100 years.

 

       All hedge funds have not been as successful, many of them reporting large losses for the period, especially those which, along with banks and high-yield debt funds, invested in Russian government debt. Many banks and funds rushed to buy Russian government bonds, GKOs, yielding 100% or more they assumed the international Monetary Fund would never let Russia collapse. The problem is Russia has collapsed and the losses are spreading around the globe, with eastern and western Europe likely to be most affected.

 

       A hedge fund is a term commonly used to describe any fund that isn't a conventional investment fund - that is, any fund using a strategy or set of strategies other than investing long in bonds, shares (unit trusts) and money markets (money market funds).

 

       Unlike unit trusts, which are subject to regulatory control and disclosure requirements, hedge funds can employ a range of both defensive and opportunistic strategies, such as using short selling, leverage, concentrated investments and derivatives.

 

       Few hedge funds are truly market-neutral. Those that are make relatively small returns. Most investors in hedge funds, however, look for larger returns. This results in most hedge funds having a directional bias, either long or short. A long bias allows them to profit when stock markets climb, but unless they are perceptive enough to identify market downturns in advance, they suffer losses when markets correct - though they are usually smaller losses than long-only funds such as unit trusts. Nonetheless, historical data indicates that a diversified portfolio of hedge funds generates more consistent returns than unit trusts, especially in potential bear markets like today's.

 

       For example, in 1987, the year of the stock market crash, while the Standard & Poor's 500-stock index rose 5,24% and growth mutual funds only 1,02%, hedge funds returned 14,49%. Again, in 1990, when the S&P and equity growth mutual funds registered returns of 3,11 % and 3,82% respectively, hedge funds finished the year up 10,97%.

 

       That's because many hedge funds, as the term implies, "hedge their bets". They may sell shares short to cover themselves against a drop in stock prices. They may buy put options - the right to sell a stock at a spec-ified future price - in order to lock in a sell price in the event of a severe drop. They may buy interest-paying bonds or trade claims of companies undergoing reorganisation, bankruptcy, or some other corporate restructuring, counting on events in a company, rather than more random macro trends, to affect their investment.

 

       By the same token, these defensive strategies tend to cause hedge funds to under-perform unit trusts and mutual funds in bull markets.

 

       Furthermore, not all hedge funds are defensive. Because the term "hedge fund" is applied to a wide range of alternative funds, it also encompasses funds that may use high-risk strategies without hedging against risk of loss.

 

       For example, a global macro strategy may speculate on changes in 'countries' economic policies that affect interest rates, and consequently all financial instruments, while using plenty of leverage. The returns can be high, but so can the losses, as macro managers such as Michael Steinhardt, Julian Robertson and Leon Cooperman learnt in 1994.

 

      That year's losses gave hedge funds a bum rap by the media, fuelling a popular misconception that all hedge funds are risky. In reality, while it is true these managers' strategies of placing large di-rectional investments in stocks, currencies, bonds and commodities and using lots of leverage can create huge returns with high volatility, a small percentage of hedge funds use strategies such as these. The vast majority of hedge funds make consistency of return, rather than mag-nitude, their primary goal,

 

       Among the strategies is merger arbitrage, which attempts to take advantage of the movements expected to occur in the stock price of two companies undergoing a merger.

 

       Mortgage-backed securities investing, another strategy, involves taking an ownership position in a group, or pool; of mortgage loans, seeking the steady-returns of fixed-income investments -but with higher yields than Treasury or corporate bonds. The strategy of market-neutral funds is to invest equal dollar amounts in long and short positions, usually in the same sector of the market, in the expectation that those stocks they are long on will rise more than the shorts in bull markets and fall less than the shorts in bear markets.

 

       There are probably as many different hedge fund strategies as there are animals in the zoo. This broad range and the many complex styles can confound the lay person. Unless you have a strong understanding of the risks associated -with the different hedge fund strategies, the best approach for investing in hedge funds is to use a consultant well versed in hedge fund strategies or to invest in a fund of funds.

  

Dion Friedland is chairman of Magnum Funds


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