Hedge the risks of bad markets

Q: I am interested in investing in hedge funds. How do you tell which is a reputable and profitable one, and how do you go about the process of investing?

A: Hedge funds are essentially private investment funds that charge a performance fee, typically a percentage of the fund's profits, for the services of the fund manager. People are willing to pay these fees because strong financial performance will enrich both the investor and the fund manager.

The idea of a "hedge" fund is that it looks to offset potential losses by hedging - protecting the sum of its original investment via a number of methods. When one evaluates a hedge fund as a potential investment option, you should look at the volatility of returns, the Sharpe Ratio and correlation to overall markets.

Standard deviation

The volatility is defined as the standard deviation of returns i.e if the returns are high in some months and then big negative returns in future months which would indicate high volatility.

Typically, you want to invest with a hedge fund which has consistent returns in good and bad markets - i.e. low volatility (a hedge fund which returns one per cent to two per cent per month in good and bad markets)

The Sharpe Ratio is the return relative to the risk being taken. So for every unit of risk we take, the return should be 1 or greater. A Sharpe Ratio which is less than one means that you get less return for every unit of risk.

A Sharpe Ratio greater than one or near one is generally good.

The correlation of the hedge fund looks at its returns relative to the overall market in which it invests. If the hedge fund is highly correlated with the overall market then you may be better off buying a pure long only fund which charges lower fees.

Typically a good hedge fund should have low correlation with the market when the latter is going down and higher correlation when the markets are rising.

Good hedge funds should make you money in good and bad markets as they have the ability to short stocks.

The complexity of hedge funds is often aligned with a certain degree of secrecy. Part of the commercial strength of a particular hedge fund is its overall size - some funds are worth billions of dollars - and the methods these deploy. By not divulging these details, funds are able to operate more effectively and exert greater influence over specific markets.

The UAE is taking a lead in the regulation of hedge funds. At the end of last year, the Dubai Financial Services Authority (DFSA) issued its Hedge Fund Code of Practice - first of its kind to be issued by a financial market regulator.

Best practice

The Code sets out best practice standards for operators of hedge funds in the Dubai International Financial Centre (DIFC) and it's certainly worth being aware of its contents before embarking on the process of investing.

If you're still with me after all this description, and feel that the hedge fund route is the right one for you, there are a few other areas to consider in choosing where to invest. The first aspect to examine is performance. Although past performance is not necessarily a guide to the future, looking at the returns from a fund over a mid- and long-term period should give you an insight into the potential for return on your investment.

It should also give you some insight into the fund's strategies, its capacity to recover from set-backs and the comparison between its performance and that of the stock market or bond market.

Beyond that, you need to be confident of the ability and track record of the fund manager.

- The writer is director of sales at Nexus, a leading regional financial adviser. The opinions expressed above are the writer's and don't necessarily represent the views of Gulf News.
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