John Andrews says investing is like motoring: it’s not the vehicle that’s dangerous but the way it’s driven
Dave wins millions on the lottery, and the first thing he does is sprint down to the nearest Ferrari showroom and jump into the latest model with extra-deep bass woofers and a little fold-down table for his can of Red Bull. His mother spits out her tea with fright. ‘You’ll kill yourself!’, she screams. ‘Why don’t you buy something safer, like a Vauxhall?’ ‘Mam’, he says, ‘if I drive the Ferrari at 200 mph down the wrong side of the M1, blindfold…’ his mother starts to hyperventilate, ‘…you’re right, I’ll kill myself. But if I drive it at 4 mph in the middle of a field, nothing will happen. It’s not the car, it’s how you drive it.’ Mam goes to put the kettle on, and thinks for a while. She comes back. ‘All right,’ she says, ‘I don’t mind about the Ferrari. But you must promise me one thing — you won’t go putting any of your money into one of those hedge fund thingies, will you?’ Dave sighs and says: ‘Mam — what I said about the Ferrari? Hedge funds are just the same.’
Now while Ferraris get nothing but a good press, you can’t say the same about hedge funds. Occasionally a big one hits an iceberg, making a field day for the I-told-you-so brigade. You may well have read recently about a US-based fund called Amaranth, which — although the full story is yet to emerge — appears to have made some catastrophic but actually rather simple mistakes speculating on natural gas prices. Then you’ll see headlines like ‘Hedge fund manager buys Monte Carlo!’ And it’s true, the top managers do make wagonloads of money — just like top footballers, pop stars, disc jockeys and celebrity chefs. But because hedge funds are comparatively new, they are starting to have the arc-lights of the media turned on them. And because the cousin of new is change, and change is often unpopular, pundits are lining up to take a swipe at hedge funds and explain why you should cross the road if you see one coming.
In these pages back in June, Jonathan Davis suggested that novice investors should be wary of hedge funds. I appreciate his caution; but his comments are just as applicable to conventional investments — and picking good investments, like most ways of getting rich, is never easy, as investors with Equitable Life will tell you. But hedge funds are here to stay, because the logic underpinning their existence is as solid as a rock. Here are just a couple of reasons why.
Hedge funds are part of a larger group of investment vehicles sometimes called alternative investments, and sometimes — more accurately and less emotively, I think — called ‘non-traditional’. (This neatly contrasts them with traditional investments, the ones we know and love: funds which invest in shares, bonds and cash accounts. These latter funds are familiar, and familiarity breeds comfort; except they have an annoying habit of sometimes losing lots of their value, which is, financially speaking, like slamming your fingers with the piano lid.)
The phrase non-traditional applies in two ways: first, in the range of available markets in which hedge funds can trade, and second, in the techniques they use to trade these markets. While these funds often buy shares and bonds and so on, they can also trade in commodities such as sugar and gold, in currencies and other instruments. Trading in this expanded range of markets simply increases their opportunities for making money. Done intelligently, it can also act to make them less risky. This gives them an advantage over traditional funds, especially at those teeth-gnashing times when all the world’s stock markets are heading like lemmings over the precipice.
Unlike lemmings, however, hedge funds have all sorts of anti-gravity packs attached to them, and this is where the non-traditional techniques come in. One of the simplest but most powerful of these is a cunning but actually quite old technique called short selling, in which you essentially reverse the buy-and-expect-it-goes-up approach. You can make money when things go down — and this effectively doubles your money-making opportunities. It’s not complicated; just not so well known.
The effect of techniques like this is that these funds tend not to behave in the same way as traditional investments. This is pos-sibly the single most important aspect of hedge funds, and one that is often overlooked: having both traditional and non- traditional investments in your portfolio means that you increase your chances of making money in the long run, whatever the overall conditions in the markets. It’s a bit like having a stand on the beach in summer — if you offer customers ice-creams and umbrellas, you’re likely to end up richer than if you sell just one or the other, especially in Britain.
So here are some important advantages that hedge funds enjoy: they can make money in markets that other funds can’t; and they can make money when markets are going down. Furthermore, they can smooth out your portfolio’s overall performance. Every home should have one, and let me stick my head above the parapet: in the not-too-distant future every home will have one, directly or through a pension fund.
Traditionally the preserve of the rich, hedge funds are inching their way into the mainstream. In Britain, for instance, while standard hedge funds are still not freely available to the general public, some investment vehicles with hedge-fund-like characteristics have recently been authorised. Offered by the likes of Merrill Lynch and Credit Suisse, these are often described as ‘absolute return’ funds, which means they are designed, in theory at least, to be capable of making profits irrespective of whether the main markets are going up or down. They are allowed to use some, but not all, of the techniques that their older brothers have been practising for years; ask your investment adviser about them.
Using a little lateral thinking, there’s another, indirect way to take advantage of the success of hedge funds, and that’s to invest in the publicly traded shares of a hedge fund manager, rather than in a fund itself. Over the past few years some managers’ shares have done incredibly well, reflecting not only the strong growth in this area, but also the market’s increasing understanding that these are solid, well-run companies. There aren’t many on the stock exchange yet; best known is Man Group, and there are also RAB Capital and one or two others. No doubt there will be more.
Dave is watching tennis on the telly. Roger Federer’s playing, and winning again. Anyone can play tennis, Dave thinks; it’s not that difficult. But to play as well as Federer is a very different story — another analogy with hedge funds. Some people are just better at it than others. Dave isn’t sure yet how to pick the Federers of the hedge fund world — but he knows it’s worth a try. Whatever his mam might say.
Dr John Andrews is a consultant to the investment management industry, a non-executive director of Aspect Capital, Geneva and a former executive of Man Group.