SMSF Investing Education & Strategies

Hedge Funds

Hedge funds, also known as 'absolute return' funds are managed investment funds that undertake a wider range of investment and trading activities than the traditional long-only managed funds that most investors are used to. Each fund has its own investment strategy that specifies the type of investments and the investment methods it undertakes.

They are similar to managed funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. The general objective of a hedge or absolute return fund is to provide investors with positive returns in most market conditions. They try to accomplish this by (as the name suggests) hedging out some of the risks inherent in their investments using a variety of investment methods. These methods mostly include short selling, using derivatives, and increasing allocations to cash to get out of particular asset classes in times of trouble. Whilst this all sounds great, there is no guarantee these methods will actually work in your favour. Investment markets don't make it that easy. There is an art and a skill to using these instruments, and it really comes down to the skill of the individual portfolio managers as to whether of not the use of these techniques will actually add value to the investment process and enable the fund to succeed in it's investment objectives. A quick look at the performance of the fund during both bull and bear markets will show you how they have gone historically over the cycle. Whilst it doesn't guarantee future success, it does give you a useful guide.

Now, apart from hedging and risk management, the term hedge funds can also include funds that use derivatives and gearing to speculate on the direction of various markets and use leverage to amplify the potential returns. Now, this is where things can get hairy. Leverage can certainly work for you, but in times of market upheaval and portfolio losses, it can badly work against you and can wipe out an entire fund (yes, this has actually happened many times before). So you need to be very mindful of the level of leverage a fund is using, and the instruments its using to accomplish this. One of the big drawbacks of hedge funds in the past has been a lack of transparency, such that investors don't know how much leverage they had or how their funds were invested. Make sure you do your due diligence and ask the questions before investing.

Where do they fit in a SMSF investment strategy

Single asset class

This type of fund is one which invests into one asset class, but uses these hedge fund type techniques to smooth investment returns through the cycle. An example would be say an Australian shares fund, which invests in Aussie equities but also uses some short selling, or put options, or cash weighting strategy etc to hedge the portfolio in times of poor share market conditions. In this case, the investment would form part of your exposure to Equities in your investment strategy, it's just that your using a fund that tries to smooth out the investment returns over time using various techniques.

Multi asset class / strategy

This type of fund is one that can use a variety of asset classes and investment techniques, which can change rapidly based on what is happening in financial markets at any point in time. With these types of funds, it's almost impossible to assign them to a specific asset class, due to their diversified nature and the changes in their allocations from one week to the next. In this case, you can create a "Hedge Fund" asset class in your SMSF investment strategy, and any investment in these funds will form part of that exposure. These types of funds (including "Fund of Fund" hedge funds) tend to have a low correlation to the performance of traditional asset classes such as shares, and as such they can provide useful diversification when part of a diversified, prudent SMSF investment portfolio.

Any of the above funds with borrowings / gearing should be treated with caution, with only sensible, prudent allocations made to geared funds within the context of your overall asset allocation and risk parameters. 

What funds are available ?

Most absolute return funds available in Australia are based on investing within the equities asset class, with a number of sub sets of strategies that can be applied (e.g. long short, relative value, market neutral etc). There are over a hundred absolute return managers available in Australia who are licensed by ASIC, with over two hundred different funds available across a variety of Investment Strategies and styles, different underlying assets, and a range of geographic mandates.

Note that many of these funds (but not all) are only available to investors who qualify as a "wholesale" investor under the Corporations Act. This is probably the biggest drawback of this sector, in that you can be quite limited in what you can invest into if you don't qualify as a wholesale investor.