Industry sources put the size of the hedge fund sector at the end of last year at $60 billion, spread across nearly 200 hedge funds. This was up from $45 billion at the end of 2005 and $26 billion at the end of 2004. Hedge funds have always had the shady allure of knowing you may make money, but not necessarily knowing the intricacies of how. Typical hedge funds will use leverage and derivatives and many hedge fund strategies seek to reduce market risk specifically through the use of derivatives. According to a recent report by Bloomberg, hedge funds borrowing to invest in collateralised debt obligations (CDO) now accounted for 33 per cent of the CDO market.
It is important then that when investing in these sorts of funds, that they are correctly labelled in your clients' portfolios. Hedge funds invest outside the universe of investment-grade defensive fixed interest products of government and corporate bonds, bank bills, convertible notes and preference shares. They may invest in a number of CDO securities of varying levels of debt from super senior to subordinated debt. While there is nothing wrong with assuming that debt for the right return, the investment should never be considered a defensive fixed interest investment.
Hedge funds should always assume a place in the alternatives allocation of a portfolio, where typically they would make up only a small proportion of a client's total investment. Basis has held the nomenclature of a hedge fund since inception, as have other Australian companies, including Absolute Capital and Mariner Bridge, but many investors believed them to be a defensive fixed interest product. A rose may be a rose and all that. But a spade is still a spade.
