When people outside the financial world hear the words “hedge fund” many are immediately taken back to the 1987 classic movie ‘Wall Street’ and Gordon Gekko, or Bobby Axelrod in the HBO series ‘Billion’ including big money, fast cars and a winner takes all mentality.

A hedge fund is an alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets.

While many hedge funds exist to invest in traditional securities, such as stocks, bonds, commodities and real estate, they are best known for using more sophisticated (and risky) investments and techniques.

What is a hedge fund?

As with all funds, a hedge fund is a pool of money used to invest in ‘alternative assets or strategies’, including the use of derivatives, alternative investments and leverage in both domestic and international markets.

There are many different types of hedge funds that all operate differently depending on their risk tolerance, the fund’s particular strategy, what assets are being invested in & where they are located, the investment tools used and the fund manager’s skills.

It is important to outline several key terms that will pop up in this and other associated articles, those of sophisticated investors and alternative assets.

Only wholesale investors are typically able to invest in hedge funds due to their complex and often risky nature. As at the writing of this book (Jan 2020), by definition, a sophisticated investor is “an investor who has had a gross annual income of $250,000 or more in each of the previous two years or has net assets of at least $2.5 million, as prescribed by the Corporations Regulations 2001 (reg 6D.2.03 and reg 7.1.28)”.

How does a hedge fund work?

Like all funds, a hedge fund is set up to ‘pool’ capital from investors and create a larger pot of money so the fund can gain economies of scale when looking to take a position.

The fund is created by the institution and the fund manager to meet certain goals or to incorporate a certain strategy. These goals surround the type of assets the fund will focus on, their risk, their location and a range of other factors.

Hedge funds are often leveraged, meaning the fund borrows money in an attempt to magnify the returns and capitalise upon market movement, knowledge on insights with a larger position than otherwise available from investor funds alone.

Hedge funds have the ability to make or break companies, industries with some of them having as much (or more) available capital than many countries! For example, the largest hedge fund manager in the world – Bridgewater Associates manages $150 billion in invested capital for around 350 of the largest and most sophisticated investors around the world.

How do hedge funds make their money?

Hedge fund managers don’t just run their funds out of the goodness of their hearts; they are in it – like the investors – to make money. Viewers of the TV program Billions, will be more than familiar with the term “2 and 20”.

“2 and 20” refers to the fees that the fund manager receives for service. That gives the manager 2% of the asset invested and 20% of the profit every year. Regardless of whether the fund makes a profit or not, the 2% is payable, while the 20% is only on the profits generated by the fund. Although this may seem rather high, due to the fact hedge funds often have very aggressive investment goals, and are very lucrative in producing strong profits.

What types of hedge funds are there?

There are nine (9) key hedge funds that investors should be aware of if they are considering investing in a hedge fund as part of their portfolio.

Long-Short Funds:

As the name suggests, the manager holds both long and short positions to capitalise on stocks they feel will over and underperform and to capitalise upon this market movement.

There are two main types of long-short funds:

Market neutral funds are used to hedge against market movement, as they have the same level of exposure to bullish (long) and bearish (short) positions in the market, making them as the name suggests.

Convertible arbitrage funds, purchase ‘convertible securities’ such as bonds in a company and short sell its common stock. 

An example of such a fund is offered by Invesco in the Australian market.

Event-Driven Funds: 

Event-driven strategies are equity-oriented strategies involving investments, long or short, in the securities of companies undergoing significant change such as spin-offs, mergers, liquidations, bankruptcies and other corporate events. Examples of these funds are those such as Blackrock.

These funds offer huge profit-making potential for funds that can predict the potential outcome that the event has not only on the company, but the market as a whole – regardless of being a long or short position. Often this is where hedge funds get a bad reputation for betting against companies and essentially sending them to ruin to make a profit.

Macro Funds: 

Macro funds are those such as Bridgewater Associates that invest based on economic trends, such as inflation and FX rates, as well as gross domestic product readings.

As the name suggests, it is looking at the large ‘macro’ trends rather than at an industry, company or market specifically.

Distressed Securities Funds: 

Hedge funds such as Oaktree Capital look at distressed securities that are primarily debt securities, which originate from companies that are in the process of reorganisation or liquidation under local bankruptcy law or companies engaged in other extraordinary transactions, such as balance sheet restructurings.

Trading in distressed securities can be inefficient, due to the fact the company is being forced to sell.

These funds often look to either pump the company for sale, or dismantle it and sell off the individual assets should they hold higher market value than the price they are able to negotiate to often desperate company shareholders and executives that will often take ‘pennies on the dollar’.

Emerging Market Funds: 

As the name suggests, these hedge funds look to capitalise on markets or portfolios of companies in emerging markets that offer untapped growth opportunities.

In terms of location, these are often in markets across China, India, Indonesia and even developed economies such as Australia & the USA who have markets that are emerging or moving. Examples of these funds are that held by Fidelity International.

Long Only Funds: 

These hedge funds look at high-quality funds that can be considered ‘undervalued’ and having a positive outlook for the future company, market or industry development.

The fund takes a long-term position to purchase and hold the stocks in generally 25 to 35 companies in the hope the capital growth is realised. Examples of these funds are the Australian based L1 Capital Investment Fund.

Short Only Funds: 

On the opposite side of the coin, short only hedge funds – although rare – look to provide exposure to declining markets such as that offered by Tradewind Capital – this is essentially betting that the market or value of a company will go down, not up.

These are often created by activist investors, who are looking to create a negative impact on a reprehensible business model, such as those run by Bill Ackman who tackled companies such as Herbalife in the USA.

Fixed Income Arbitrage Funds: 

These hedge funds look to capitalise upon mortgage-backed securities (MBS), government bonds, corporate bonds, municipal bonds and even more complex financial instruments such as credit default swaps (CDS) which ultimately caused some of the mass losses (and gains for some) when the property market crashed leading to the 2008 GFC and was the subject of the movie, The Big Short.

When there are signs of mispricing in the same or similar issues, fixed-income arbitrage hedge funds take a combination of leveraged long and short positions to profit when the market pricing is correct.

Aberdeen Standard has such fixed-income funds available within the Australian market.

Merger Arbitrage Funds: 

These hedge funds seek to create ‘risk-free profits’ by purchasing & selling simultaneously the shares of two merging companies to create a profit in the discrepancy in share price and the price being offered by the acquiring parties of the companies.

Timing is everything with these merger arbitrage funds, however, they can yield significant results. Silver-Pepper investments have such a fund available to sophisticated hedge fund investors.

Hedge funds are incredibly high stakes, high reward, high-risk instruments that are not for your average mum & dad investor – unlike an Exchange Traded Fund (ETF). They are geared towards sophisticated investors who have access to large amounts of capital or assets and are looking to either profit, hedge or influence markets.

Should a hedge fund be included as part of your personal investment strategy, it is always best to get independent, expert advice before committing to a fund and ensure that your due diligence and research is complete and accurate, as losses can occur on a much larger scale due to the size of the required outlay.

There are many types of ‘funds’ that exist within Australia; however, unless you are positioned within the financial services industry, or you are a wholesale client by definition of the Corporations Act 2001, chapter 7 (for example, at the time this book was written, you had an annual salary exceeding $250,000 in two consecutive years or net assets exceeding $2.5 million) you are more than likely to not have too much knowledge around the managed funds available.

By definition, a managed fund is a type of ‘managed investment scheme’ in which your investment or money is pooled together along with others. With a fund created, the fund manager then buys and sells shares or other assets on behalf of the funds.

Every working Australian, must by law set aside money during their working life to support their retirement. This system is known as Superannuation. With your superannuation, the Australian superannuation guaranteed rate of 9.5%, which will rise to 12% by 2025 is paid into your superannuation fund by your employer. A superannuation fund is similar to a managed fund in that the funds are pooled and managed by an Investment Manager, however a superannuation fund is specifically created to ensure your financial security in retirement for those who are members of the superannuation fund.

As a holder of superannuation, you can log into your super account and see how much you have, what investment mix your portfolio is set up to achieve, what assets your money is invested in and how the performance is tracking.

There are several differences between a superannuation fund and a managed fund, some of which are:

• you are a member of a superannuation fund whilst you are an investor that holds units in a managed fund;
• your investment increases periodically whilst you are working as your employer makes super contributions to your superannuation fund; and
• by law unless you have ‘exceptional circumstances’ you can’t access your super until you are 65 or have permanently retired from 55 to 60 years old, depending on a range of circumstances.

A managed fund works slightly differently

A managed fund pools multiple investors’ money into a fund, which is professionally managed by specialist investment managers. You can buy into the fund by purchasing units or shares. The unit’s value is calculated daily, and changes as the market value of the assets in the fund rises and falls.

Each managed fund has a specific investment objective, typically focused on different asset classes and a specific investment management philosophy to provide a defined risk/return outcome.

Investing in a managed fund is not mandatory like superannuation but it essentially operates in the same way.

Unlike with your super, as an investor in a managed fund, you are usually paid income or 'distributions' periodically. The value of your investment will rise or fall with the value of the underlying assets.

What are managed funds used for?

As with many funds and financial instruments for that matter, one of the major uses for managed funds is diversification. This is done through managed funds by spreading the risk of the investments with different types of shares or levels in different asset classes, including stocks, bonds, commodities, currencies, ETFs - you name it.

With the managed fund pooling the resources from a range of investors to realise economies of scale, it can then amplify their positions through not only adding additional investors to the pool but also taking a margin loan out against the funds in the position – should the risk tolerance of the fund allow it to.

When investing in a managed fund, you are paying a percentage and fees to expert fund managers, who are responsible for the performance of the fund, picking the financial instruments being traded and managing investors’ money in a responsible and effective way.

With access to analysts, market data, insights and research that is far beyond the time and scope available to individual investors, the decisions made within the managed funds should always be backed by research.

Another benefit of managed funds is compound returns or reinvested products and distributions being allocated back into your fund. This allows any future performance of your investment to be now based on a larger amount – thus compounding – rather than pulling the profits from the managed fund.

This form of investing in funds is what is commonly termed as ‘passive investing’. That is to say, as an investor, you are putting your money and its future performance to work through giving it to someone else to manage.

By doing this, you absolve yourself of the responsibility of the day-to-day checking, trading, research and updating, while your fund manager who has access to a wealth of time-critical data, teams of analysts and decades of market experience takes the wheel and drives your money harder.

What type of managed funds exists on the market today?

Although there are six (6) main types of managed funds on the market today, there are many more varieties of funds, providing a spectrum of assets allocated based on the risk profiles, desired outcomes and what the money is being invested to achieve.

• Active Funds, as the name suggests, work to outperform the index that it is tracking through active management of the managed fund account.
• Index Funds, also known as ETFs or exchange-traded funds, aim to provide investors with performance in line with the particular index that it is tracking – whereas the active funds are looking to outperform the market.
• Single Sector Funds, work within a particular asset class, such as SME’s or FinTech and the performance of players within that space.
• Multi-Sector Funds have a diversified approach across a wide range of asset classes all with varying risk levels attached.
• Income Funds are geared towards a defensive holding strategy, income generation but minimising risk at the same time. These funds are often sought out when market volatility strikes markets, industries or economies.
• Growth Funds are long-term investments focusing on capital growth, rather than income-based. As such, they are typically geared towards shares in growth companies and sectors to capitalise upon their long-term positions or outlooks.

Depending on your personal investment strategy and financial goals, you may opt to invest in one or a combination of funds to ensure your risk is spread, and you are achieving the desired outcomes.

Should you be looking to hedge your investment portfolio with a safe bet looking to invest in income funds may be the strategy to employ, meanwhile, should you be looking at the ‘long game’ in terms of investing money for 5+ years, then a growth fund or even an index fund could be an ideal avenue for investment.

While index funds – as well as active funds – also offer investors access to invest in a range of financial assets in emerging markets or specific industries, so they also offer significant short-term opportunities as well.

The key is under careful & experienced management; a managed fund offers significant advantages for almost all retail investors.

What type of fees can you expect on a managed fund?

On a managed fund, the fee structures can vary depending on the structure of the fund, the financial instruments that are being traded as well as the potential risks involved with the fund, not to mention the fund managers themselves, their background, past performance etc.

However as quoted from the Sydney Morning Herald, “based on an initial investment of $50,000, the average investment management fee paid by individual small investors for multi-sector balanced managed funds is just under 1 per cent but can be as high as 2.5 per cent. Average "retail" fees – those paid by individual investors - on multi-sector "growth" funds are 1.16 per cent and 1.18 per cent on multi-sector "aggressive" funds”.

What are the next steps when looking into a managed fund?

If you are considering a managed fund as part of your portfolio, as with all financial products, it is always important to speak to an independent expert before doing so to ensure that the funds meet with your investment strategy and particular risk tolerance.

Many fund managers have a minimum investment of between $5,000 and $250,000 for retail investors, making them out of reach for smaller investors. However, with ETFs or exchange-traded funds that are listed on the ASX, there are other options should you be looking to dip your toe in the managed fund water sooner.

Remembering that online stockbrokers – such as IG, CommSec or CMC Markets Stockbroking - typically charge anywhere between $10 and $20 brokerage for a $100 trade, which even at the low end of the brokerage scale, this means that with every $100 worth of shares you should expect to pay at least $10 in brokerage, as a rule of thumb.

Like with all investments, you need to consider your personal investment goals, your tolerance to risk and the amount you are looking to invest and for how long. These decisions will have a bearing on which fund you may end up looking to invest in, and also the managed fund provider you go to work with.

As with all financial decisions, as an investment, it is prudent to research and seek professional advice before making any finite decisions.

Managed funds are not exclusive to sophisticated investors or high net worth individuals. They offer significant advantages to investors who wish to spread their investment and risk across a range of shares of financial assets, rather just in one particular company or asset class.

Although there are many hedging and risk benefits to this approach, there are still risks involved, and these should be assessed before investing in any hedge fund.

When many of the most well-regarded brands and businesses were coming through the ranks, they had to do it the ‘old fashioned way’, go to the banks – or the bank of mum and dad – take a loan, and grow ‘organically’. Take Phil Knight, for example, the CEO and Founder of a little-known brand – Nike.

He had an almost monthly battle with his little bank branch, on how much he could borrow, how much ‘equity’ or how liquid his business was, and essentially, they controlled his growth trajectory for many years. In fact, the Nike you know today may have never come to fruition had it not been through the tenacity of Mr Knight.

Today, businesses are supercharged by venture capital, in fact most of the companies you use every day – Facebook, Google, Twitter were just that. “Venture capital is a form of private equity and a type of financing that investors provide to start-up companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks and any other financial institutions”.

As can be expected, within venture capital, there are a number of key stages:

• "seed stage" venture investors help get a company off the ground; think $0-$1MM of revenues.
• "early stage" venture investors focus on taking a company that has successfully proven its concept and help them to accelerate their sales and marketing efforts; think $1-$10MM of revenues.
• "growth stage" venture investors basically pour kerosene on top of a company that is already "on fire"; think $10-$50MM of revenues.

Venture capital is almost solely responsible for the rise of the ‘start-up’ revolution. Gone are the days of needing a massive amount of cash to get your business idea off the ground. You need a compelling idea, a pitch deck and a good work ethic, and VC can do the rest.

Venture capital in a way can be providing the seed funding for a friend’s new online business, or providing second round (early stage) funding to your siblings café – it isn’t just about the big end of town.

If you were a VC funder in companies such as Facebook or Alibaba, you would not be reading this book; you would be on an island somewhere. However, with as many as 75% of VC backed companies failing to return dividends to their investors, there is a risk in any investment through VC.

Venture capital is something that requires not only the capital but also the time, patience and risk tolerance if you were to look to invest in it. As a new investor, Venture capital is not recommended, however, you could indeed invest in a fund that engages in venture capital.

Again, although there are many success stories when it comes to venture capital, it has most certainly made many people very wealthy, you should always seek advice before delving into an area with such high expectations, and such high total loss rates.

According to Walter Davis of Invesco, alternative strategies are those investments in anything other than publicly traded, long-only equities & fixed income.

These include:

• An investment that encourages shorting, global macro, market neutral and long/short equity strategies
• Investing in any asset class other than stocks or bonds
• Investment in illiquid or privately traded assets such as private equity, venture capital and private credit.

However, for the purpose of clear definition in the Australian market, we should include property investment in the pool of traditional investing, due to the high level of homeownership and investment in Australia, which was at 65% in 2016.

What do alternative investments offer?

Alternative investments offer opportunities in global markets by providing 24 hour/7 days per week trading platforms – such as CFDs - while also having the opportunity for leverage, meaning you only need to pay a fraction (the spread) of the total trade to execute the trade.

They allow savvy investors to bet against the market, to make trades on movements before they happen, and reap the rewards should they come to fruition. However, the risks of alternative investments are greater than simply the loss of the amount invested (the spread), as the total trade and any losses need to be repaid for any unsuspecting investors.

Meanwhile, investment in alternative asset classes such as art & collectables provides diversification and capital growth opportunities, as well as the potential for incremental revenue from leasing or loan arrangements to private or corporate clients through brokers.

With any investment, there are risks and potential losses that may insure and should be considered before commencing any alternative investment strategy. Alternative investments offer just that, an alternative.

To effectively leverage the opportunity, speaking with a managed investment fund, will allow investors to pool their funds and the scheme to be operated by an expert in alternative investment strategies – making the ROI potential even greater than if you go it alone.

Tangible Investments

Tangible investments or those that are physical in nature, different to that of shares, securities or currencies as the name suggests, due to the fact they are tangible.

Tangible assets exist outside of an account balance, financial statement or exchange market. Put another way, tangible assets have a physical form and natural value. It's likely that you have already invested in physical assets in some way – you may have bought a house or car, collected a piece of art, kept a family heirloom, or bought gold or silver jewellery.

Many people prefer investing in tangible assets as they can physically hold them, see them, touch them, but this is in ‘most cases’, as with many tangible assets, you are buying them in containers, or as part of a shipment with the intention of selling them for a higher price in the future.

Commodities

Commodities are those assets such as coffee, gold, metals, grain, and fuel that can be produced in a raw form then bought and sold on the open market. They are often either raw materials or primary industries such as mining and agriculture and can include live trade markets, such as cattle and sheep.

There are several ways in which investors can delve into investment in commodities. Firstly is to invest in the physical asset, such as metal, grain, fuel barrels and more. They can then look into investing in the same asset class, but investing in ‘futures’ in those assets. This methodology is often used by a business looking to ‘hedge the price’ they pay on assets they use a lot of. For example, transport companies and airlines often purchase futures in the fuel process to hedge against adverse movements in commodity pricing.

“Investors can also invest through the use of futures contracts or exchange-traded products (ETPs) that directly track a specific commodity index. These are highly volatile and complex investments that are generally recommended for sophisticated investors only”.

Real Estate

Often one of the largest investments most people will ever make in their lifetime, real estate has for decades been the cornerstone of the ‘great Australian dream’. However with Australian housing prices, especially those in the major capital cities, skyrocketing, then crashing, then jumping up again, they have moved from a ‘safe house’ to almost a speculative instrument in some markets.

Real estate investment is much more than the investment in the family home. There are huge benefits both in terms of income and tax when you invest in other property such as an investment house or apartment, commercial real estate or even factories and warehousing.

Although real estate investing is a tangible investment, there are also investment opportunities within the real estate sector in which you as an investor don’t own the whole asset, but parts of it. This can be done in several ways, two of which are micro-investing and investing in a real estate fund.

Similar to the company Brick-X, micro-investing has become popular in the time of the millennial, as more and more people feel they are ‘priced out of the real estate market’ and can’t comply with the ever-increasing and ever-changing banking hurdles to get a home loan.

The second example of ‘alternative investments’ in real estate is funds, also known as development funds. These are often used by property developers to fund the purchase, design, development and marketing of properties so that they themselves do not need to foot the bill – or the risk of such an investment – entirely.

Infrastructure

Investing in infrastructure is one of the more ‘complex’ tangible investment vehicles, especially in comparison to purchasing a house or apartment. However, before you think you can invest some cash and pay for road work outside your home, then rename your street – think again.

“Infrastructure is one of the fastest-growing asset classes globally, with target infrastructure allocations increasing significantly over recent years. AMP Capital expects portfolio allocations to infrastructure assets to rise further in coming years as the benefits of investing in infrastructure are increasingly recognised.”

Investment in this asset class is done through a fund, as typically governments themselves fund – or are supposed to fund – large-scale development in the infrastructure needed around the country, or the world for that matter.

However, when the government runs short of money, or are looking to allocate those much-needed funds to other projects, institutions using investors’ money offer significant returns through infrastructure funds.

Alternative Investments

As an investor, it is paramount that you diversify your portfolio for a wide range of reasons. Most of all, it is to hedge your risk against volatility in any one company or asset type.

Extreme volatility has been felt across traditional investment avenues with 2018 viewed by many as the worst year since the GFC. Australia’s largest housing markets in Sydney (-10.4%) and Melbourne (-9.1%) dropping significantly since the highs of mid-2012.

The global financial markets are in turmoil with trade wars, potential impeachment of sitting US President Donald Trump, not to mention industry disruption, innovation and fluctuating commodity prices across the globe placing a feeling of uncertainty upon investor's portfolios.

Investing in alternatives to not only hedge but to prosper is becoming an attractive option to many investors due to such instability across assets that were considered well, as safe as houses.  

From investment in art and collectables, which across the globe accounts for an estimated US$1.62 trillion in art and collectible wealth held by UHNWIs in 2016, and an estimated US$2.7 trillion by 2026, wealth managers seem to realise both the financial and emotional value attached to art and collectibles.

With traditional investment paradigms offering ownership of an asset or shares in a company being moved aside, as investors see the value in purchasing certificates – such as through blockchain, betting for or against market movements through leverage (such as CFDs and FX trading) and looking outside the traditional ways of investing for new opportunities.

Share markets enable businesses, governments and organisations to raise capital, which can allow companies to expand their operations, invest in new infrastructure and ideally grow. In return for this capital, investors receive a ‘piece of the company’ by way of shares – which can be lucrative should the company be successful.

In addition, if a company decides it wants to raise money and have its shares traded on a stock exchange, it will sell shares to investors in what is known as an initial public offering (IPO)[7]. An IPO allows the company to become listed, raise capital or ‘payout’ the original owners or shareholders for their hard work in getting the company to its current stage, and continue its journey from there.

The share market has risks and is exposed to volatility and individuals, companies, institutions and governments can all realise large capital losses should the market turn against them or they make an informed investment.

The best advice is to seek advice, undertake education and speak to professional advisors before entering your journey on the share market.

[7] https://www.commsec.com.au/education/learn/investing-basics/how-does-the-stock-market-work.html

Financial markets can be an extremely unforgiving place, you cannot ‘undo’ a buy or sell, likewise just because you don’t understand or know about something, doesn’t mean you don’t have to pay out your position – with this in mind, education & knowledge is vital.

People may or may not understand all instruments at their disposal and may invest in positions that are leveraged – such as CFD’s, which only require a small percentage of the actual position or outlay to make the trade – which could cost you a lot of money.

There are a number of excellent share market books, such as ‘Starting out in shares – The ASX Way’ that can provide a basic understanding. While most share trading platforms have their own training platforms – such as the IG Academy – which have a wide range of information, interactive exercises, quizzes and videos to help you learn how to trade using their platforms and what everything means.

Meanwhile, the ASX sharemarket game provides an informative and interactive game for the general public and schools to proactively learn the basics, and start trading shares through a portfolio of ‘fake money’ but trading on real shares, in a like-real market.

This share market game provides individuals with not only the opportunity to win some great prizes but also formulate investment strategies to encourage education including learning how to watch market movements, execute trades and how to become financially literate on the share market – all before a registered user even steps foot in the investment ring.

The prices of individual shares on the share market are subjected to a wide range of factors that can affect the prices. The market and its performance are tracked using a number of measures, known as indexes.

These indexes such as the All Ordinaries – which tracks the top 500 companies listed on the ASX – provide a gauge on how the overall performance of markets, or particular segments – such as the emerging company index (XEC).

The prices on the share market can rise and fall for a wide range of reasons, outlined below:

• Company-specific – such as profit announcements, corporate restructures or new opportunities
• Market-specific – such as the announcement of the government cracking down on sugar in soft drinks and its effect on Coca-Cola Amatil’s (CCA) core market of carbonated soft drinks
• Industry-specific – The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry
• Macro-economic - such as the Chinese-US trade war

All of these specific reasons or changes can positively or negatively take their toll on the share price on the share market.

Other factors include demand & supply (how much is available to buy and how many people want to buy a particular share), interest rates (availability to money), election cycles, geopolitical risks, even activism investing, which is often led by large hedge funds in taking a position against a company they see as behaving badly to crush their share price.