TheStar
LATELY, there has been talk about buying into hedge funds to lower portfolio risk. Should I buy them now, given that there have been reports that some US hedge funds may be the next victim of the recent issue on subprime?
As a result of the recent credit crunch, some US banks and brokers may need to write down their lending to hedge funds as the latter were unable to come up with cash to meet the margin call. Some hedge funds, especially those highly leveraged, fear that their account could be frozen if their broker runs into trouble.
Besides, the cutting off of financing from a broker, like Bear Stearns, to hedge funds has sparked some fear that their broker might force them to liquidate investments to repay loans as well.
In Malaysia, we believe some US and Europe hedge funds had already pulled out their money during the previous market crash in August 2007. After the recent general election, some fund managers may also view our country as having increased political risk.
Therefore, we suspect that further withdrawal of some hedge funds could be one of the contributors to the recent weakening of the ringgit.
Even though the hedge fund party may not be over in Asia, there has been talk or promotion in the market about hedge fund products recently, which have caught the attention of some local investors. These alternative investment vehicles might seem foreign to our local investors.
However, in seeking higher returns, they are willing to take some risk to venture into these new instruments. Therefore, further education is required to help local investors have a better understanding of these alternative investment vehicles, so that they are aware of the degree of risk that they will be taking.
What is a hedge fund? The original concept of a hedge fund was to offer plays against the markets, using short selling, futures and other derivative products. At present, most hedge funds are structured as a limited partnership. They are classified by their investment strategies.
The common categories include long/short, market-neutral, global macro, and event-driven funds. Their fund managers will receive a base management fee, plus an additional incentive fee.
To get higher returns, some hedge funds may borrow to invest. In good times, it can enhance returns.
However, during any financial crisis, like the recent liquidity crisis in the US, the pullback on lending may magnify the losses.
Nevertheless, the key advantage of investing in hedge funds is that it has low correlation to other conventional investments like equity and bond. Hence, it can be used to enhance portfolio diversification and lower the overall portfolio risk.
Due to certain investment strategies, some hedge funds may claim that they have lower volatility compared with bonds or equity investments. Even though not all hedge funds will be affected by the US subprime issues, we believe that at this moment, investing in some hedge funds may result in higher instead of lower risk.
Risk will be higher when hedge funds borrow money to invest or invest in illiquid markets, which may have very high risk of mispricing. Besides, as the submission of performance by fund managers is voluntary, we may have problems to accurately track the performance record of hedge funds.
Retailers are always excited whenever they look at the historical performance of certain hedge funds. However, we must always remember that past performance does not guarantee future performance.
Besides, investors do not realise that some hedge fund reports might be misleading, as the performance period selected in the reports does not include results during a downturn.
Therefore, when evaluating the hedge funds, investors should pay attention to the time period of the report to better judge the performance of the funds.
We should only choose hedge funds that are managed by experienced fund managers. As retailers may face higher risk when investing in hedge funds, investors need to know their risk-tolerance level.
Even though some investors may have big amounts of money, they need to know whether they can accept those levels of uncertainties in returns.
Investors need to know the details and background of those hedge funds. They need to know whether they are willing to accept the risk before considering the potential returns.
Ooi Kok Hwa is an investment adviser licensed by Securities Commission and managing partner of MRR Consulting.
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